If you are an average investor looking for additional tax savings beyond Section 80C and 80D, and looking for a long-term investment option that fetches market-linked returns and assures safety of capital, the National Pension Scheme (NPS) may be an option for you.
With interest rates falling continuously over the last two years, investments such as fixed deposit and insurance-related saving products are being replaced by other investment instruments.
NPS is a scheme aimed at building a corpus for life after retirement and it comes with opportunities to earn high returns with low exposure to the equity market and tax benefits.
However, proceed carefully with the NPS after understanding its lock-in period, and concerns over taxation of annuity and lump-sum. Let’s explore the prospects associated with investment in NPS while understanding its various pros and cons.
How it works
NPS is strictly a pension-oriented investment instrument, which allows you to withdraw up to 60 per cent of the fund you have invested in it once you reach the age of 60 years.
The remaining has to be re-invested in annuity from an approved life insurer to get a monthly, quarterly, half-yearly or yearly pension. Withdrawal before the age of 60 years is forbidden unless you have made contributions for continuous 10 years, in which case you are allowed to withdraw partially, i.e. up to 20 per cent of the contribution for specific purposes such as children’s education, their marriage, buying home, etc.
Although there is no upper limit on the amount to be invested in the NPS, the minimum deposit per year has to be '6,000. The fund is allocated between debt and equity instruments and handled by fund managers. An investor can opt for a maximum of 50 per cent fund allocation on equities.
At present, investors have the option of selecting from seven eligible fund managers from different pension fund companies. Investors can change their fund managers once a year.
How NPS investment is taxed
While the amount on maturity is completely tax-free for government employees, it is partially tax-free for private employees. An additional deduction of '50,000 is provided for contributions towards the NPS under Section 80CCD (1b) of the Income-Tax Act. Twenty per cent of the total corpus is taxed if the investor withdraws over 40 per cent of the corpus.
The maturity amount invested in purchasing annuity is exempted from taxes. Only the pension earned from the annuity is taxed as per the tax slab of the individual. At the time of maturity, you can increase the annuity amount to 60 per cent and withdraw a lump sum of 40 per cent to save taxes.
Should you go for NPS?
The NPS allows you to save taxes on those extra Rs 50,000 above Rs 1.5 lakh ceiling under Section 80C. With minimum risks associated, this investment instrument provides returns of 9 to 10 per cent a year. The NPS is suitable for risk-averse investors, who do not require funds any time before maturity, as the withdrawal norms are more rigid than any other investment products in the market.
The NPS does not allow withdrawal of over 20 per cent of the contribution. The returns on annuity is relatively low and a bigger blow lands on the investor when the annuity income is taxed. Let’s assume that you invest Rs 4,100 per month under the Section CCD (1B) for 35 years and earn an average return of nine per cent a year without any withdrawal. On maturity, you get an annuity return of six per cent. Now, let’s look at two scenarios.
Case I:
If you withdraw 60% and reinvest 40% in annuity
The investment that you would make in 35 years would be Rs 17.22 lakh. The total corpus that you would accumulate at the end of the term would be Rs 1.215 crore. An investment of 40 per cent of this corpus in annuity would be worth Rs 48.6 lakh. Considering the return on annuity is six per cent, you would receive a pension of Rs 24,000 per month. The annuity income would be further subject to income-tax at the prevailing rate of the time. The withdrawal maturity amount would be Rs 72.91 lakh and you would be taxed on Rs 24.3 lakh (20 per cent of '1.21 crore).
Case II:
If you withdraw the 40% lump sum and reinvest the rest
If you reinvest 60 per cent of the corpus, the annuity fund would be worth Rs 72.91 lakh. You would earn a monthly pension of Rs 36,450 subject to the prevailing income-tax slab you fall under. You would be entitled to receive a lump sum amount of Rs 48.607 lakh, which is 40 per cent of the corpus, and it would be exempted of taxes.
Analysing the two cases, it is clear that if you claim about 40 per cent of the corpus you can defer taxes on 20 per cent of the receivable fund. The pension income would be subject to income-tax at the prevailing tax rate as per the individual’s slab.
The attractive aspect of this investment is that it allows you to save income tax for an additional Rs 50,000 over and above the Rs 1.5 lakh limit. However, to make it more attractive to investors, the government must rethink the 20 per cent taxation limit. Additionally, the returns on annuity (around five per cent) don’t compete well with other time-tested options such as fixed deposits or mutual funds. So go for the NPS if you are fine with safe, assured and conservative returns, and if you are looking to save some more income-tax.
(The writer is CEO, BankBazaar.com)
