Investing in NPS for Tax-Saving/Retirement? Beware of These Drawbacks of NPS Too

11 Feb 2021by Pradeep U

Investing in NPS for Tax-Saving/Retirement? Beware of These Drawbacks of NPS Too

Recently a friend of mine called me to know my opinion about investing in NPS for tax-saving. He told me that as he had exhausted all other options under 80C and 80D and still had some tax liability due he was exploring investing in NPS for the first time.

“So, you are planning to invest 50k in NPS to save 15k in tax?” I asked him.

He replied “Yes, as my income is falling under the 30% tax bracket. Well, not just for saving tax, but for retirement planning too. What do you think?”

Before we proceed with my answer, let’s take a detailed look at NPS, its features and the drawbacks of NPS.

What is NPS?

National Pension System or NPS is a market-linked investment scheme backed by the Government of India to provide old age security in the form of pension to an Indian citizen. The NPS Scheme is regulated by Pension Fund Regulatory and Development Authority (PFRDA and all assets under this scheme are owned by the National Pension System Trust (NPST).

Both resident and non-resident Indians (NRIs) between 18-65 years are eligible to join NPS. NRIs' contributions to the NPS Scheme are subject to RBI and FEMA regulatory requirements as prescribed by from time to time.

Overseas Citizens of India (OCI), Person of Indian Origin (PIO) and HUFs are not eligible for opening the NPS account.

NPS is mandatory for all government employees who joined service post 1st January 2004. It is not mandatory for employees for the private sector. Still, it offers an option to build a corpus for retirement in the wake of the lack of adequate social security measures or post-retirement benefits in our country.

There are two types of NPS accounts – Tier 1 and Tier 2. While Tier 1 type of NPS account's objective is to create a corpus for retirement corpus, Tier 2 account is more like an investment account with more flexibility in terms of deposits and withdrawals similar to mutual fund investment.

While registering for the NPS scheme, a subscriber has to choose a Pension Fund Manager (PFM) and scheme preference. Subscribers can choose their preferred PFM from eight PFM’s such as ICICI Prudential Pension Fund, LIC Pension Fund, Kotak Mahindra Pension Fund, Reliance Capital Pension Fund, SBI Pension Fund, UTI Retirement Solutions Pension Fund, HDFC Pension Management Company and Birla Pension Fund to manage their investments in NPS.

NPS offers four different types of funds for different types of investors depending on their risk profile, such as Ultra-safe, Conservative, Balanced and Aggressive.  The asset mix of Ultra safe fund includes 60% in Gilt funds and 40% in Corporate bond fund while in the Conservative fund investments are distributed among Gilt funds, Corporate bond fund and Equity in the ratio of 50%, 30% and 20% respectively.

In the Balanced fund, the investments are divided in a ratio of 33.3% each in Gilt funds, Corporate bond funds and Equity whereas, in the Aggressive fund, investments are divided among Gilt funds, Corporate bond fund and Equity in the ratio of 20%, 30% and 50% respectively.

By investing in NPS, one can avail an additional deduction of Rs. 50,000 under Section 80CCD(1b) of income tax.

Drawbacks of NPS

Highest lock-in period among all tax-saving instruments

Compared to all other tax-saving instruments, the NPS has a high lock-in period. One cannot withdraw their full corpus from NPS till he/she attains 60 years of age. On the other hand, tax-saving instruments like PPF, ELSS, EPF, NSC etc., have a relatively lower lock-in period. ELSS has a 3-year lock-in period, EPF can be withdrawn after two months of being unemployed while PPF has a 15-year lock-in period for complete withdrawal. Partial withdrawals up to 50% of the balance are permitted in PPF after completion of 5 years from account opening. Premature closure based on specific medical and educational grounds is also permitted in PPF after five financial years.

In 2018, the PFRDA introduced partial withdrawal norms in the NPS scheme. Under the partial withdrawal norms, subscribers are permitted to withdraw up to 25% of contributions starting from the 3rd year of NPS opening subject to certain restrictions.  These restrictions include expenses for higher education, medical treatment & construction of a house.

Taxation on Annuity

At the age of 60, i.e., on retirement, a subscriber can withdraw a lump sum of up to 60% of the fund available in his NPS account and invest the balance in an annuity plan. Annuities are insurance contracts which promise the buyer regular income either immediately or after a stipulated period.

Currently, there are 11 annuity service providers empanelled by PFRDA such as Life Insurance Corporation of India (LIC), HDFC Life Insurance Co. Ltd., ICICI Prudential Life Insurance Co. Ltd., SBI Life Insurance, Star Union Dai-ichi Life Insurance Co. Ltd., Bajaj Allianz Life Insurance Company Limited, Edelweiss Tokio Life Insurance Co. Ltd., India First Life Insurance Co. Ltd., Canara HSBC Oriental Bank of Commerce Life Insurance Co. Ltd., Kotak Mahindra Life Insurance Co. Ltd. and Max Life Insurance Co. Ltd.       

60% of the amount thus withdrawn from the NPS account is exempted from the tax liability under the EEE (Exempt, Exempt and Exempt) regime similar to total exemption for other instruments for tax-saving such as PPF and Sukanya Samriddhi Yojana (SSY) on maturity.

However, as an annuity in India is taxable, the balance 40% invested in purchasing the annuity plan will not generate tax-free pension for the investor. It does not make sense for a retired person to receive an income which is taxable as it will reduce his/her overall income after retirement.

Low returns offered by annuity plans

Annuity rates currently offered by insurance companies in India are very low in the range of 5.5-6.5%. These annuity rates are even lower than those offered by banks to senior citizens. Interest rates in India are linked to RBI's repo rate and are generally 1-2% higher than the repo rate.

In future, as India grows and transforms into a developed country from a developing country, the interest rates are likely to fall further. Interest rates in developed countries like USA, UK, Canada, Japan and Switzerland are currently meagre in the range of 0.5 to 1.5%. So, it is quite natural that in India, as interest rates fall in the future, annuity rates will also take a further dip.

At current annuity rates of 5.5-6.5%, an investment of 1 crore rupees will generate a yearly annuity of just 5.5 to 6.5 lacs. Can you imagine what will happen after 20-25 years amid falling interest rates and rising inflation?

Yes, there is an annuity option called ‘Annuity for Life’ where the investor can choose a higher rate of annuity, but in that case, the investor's nominee will not get anything on the investor's death.

Let’s understand this with a real example of an immediate annuity product named LIC Jeevan Akshay Vll.

By choosing the annuity option Annuity for Life, an investor will get a yearly annuity of Rs. 3,99,750 for an investment of Rs. 50,00,000. On the other by choosing the annuity option, Annuity for Life with Return of Purchase Price, the investor would get a lower annuity amount of Rs. 2,72,250 for the same investment amount.

In the second case, as the name suggests, the investor's nominee would get the amount invested back, i.e., Rs. 50,00,000 but remain content with a lower annuity (difference of Rs. 1,27,500) during his lifetime.

Bottom line: Is it worth investing in NPS considering the drawbacks of NPS mentioned above?

While investing in NPS, most people focus on the tax-exemption they receive but ignore the low returns and taxation aspect on annuities. NPS as an investment product for retirement would have been much better if the annuities' returns were better and tax-free.

As per data available on Moneycontrol the five-year returns of various funds managed by different PFMs in NPS range between 5 to 11.80%.  By investing in directing equity, one can generate a much higher corpus for retirement due to the longer duration available for investment.

Historical data has proved that stock markets are generally stable over the long term and have beaten all other asset classes in terms of returns. By investing in good quality stocks, one can easily generate a return of 25-35% or even higher on their equity investments over ten years or more. Click here to invest in portfolio of multibagger stocks with a potential to generate 4-5x returns in 5-6 years.


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