The NPS or the National Pension System is a voluntary retirement scheme set up by the government through which you can save for your old age pension or create a retirement corpus. It’s managed by PFRDA (Pension Fund Regulatory and Development Authority).

Any citizen of India – whether resident or non-resident – can join the NPS. The age limit for joining the system is between 18-65 (the maximum age limit was hiked to 65 from 60 in September 2017) while the contributions to your account can be made up to the age of 70. However special rules apply if you join after the age of 60. You can view them here.

It has two kinds of accounts – Tier I and Tier II. The Tier 1 account is non-withdrawable till the person reaches the age of 60, but partial withdrawal is allowed (even before 60 years) in specific cases like critical illness, children’s education, wedding expenses, buying or constructing a house. You can get more details here

Investing in the NPS has tax benefits of up to Rs 2 lakh per annum (and more in some circumstances). Up to Rs 1.5 lakh investment under NPS is covered under the overall ceiling of section 80C of the Income-tax Act, 1961, while it also gets an additional tax deduction of Rs 50,000 under section 80CCD(1B). This means a saving of Rs 61,800 for someone in the 30% income tax slab.

On the other hand, the Tier II account is more like a savings account and subscribers are free to withdraw the money as and when they require. There are no tax benefits for Tier II whether at the time of contribution or at the time of withdrawal. It works more like normal mutual fund investments except for the costs which are much lower for NPS (in the range of 0.25%) compared to mutual funds (in the range of 1.5-2%). 

The NPS Tier I Account

Your investment in the NPS Tier I is locked-in until the age of 60. You can also extend this period up to the age of 70. Before the age of 60, you can make partial withdrawals for specific purposes or you can go in for a premature exit (as explained below).

Once you open a Tier I account, you will be issued a Permanent Retirement Account Number or PRAN. As for tax benefits, your contributions and gains will be exempt from taxes while the entire corpus on withdrawal will be taxed at slab rates.

Your NPS investment is split between equities (stocks), government bonds and corporate bonds. You can either decide this split yourself (eg: 40, 30, 30 or 60, 20, 20) or you can invest in an NPS Lifecycle Fund which decides this split based on your age. You can also choose between different fund management companies.

Upon maturity, you have to use at least 40% of your investment to buy an annuity. Another 40% can be withdrawn tax-free. The balance 20% can be withdrawn after paying tax.

Tax Benefits of NPS

If you are an employee

  • Your employer’s contribution to NPS is eligible for the tax deduction with no upper limit. However, it cannot exceed 10% of your salary.

Eg: If your salary is Rs 30 lakh per annum, you can get a deduction on the employer contribution of Rs 3 lakh.

  • Your contribution to the NPS is eligible for tax deduction up to Rs 1.5 lakh. This also cannot exceed 10% of your salary.

Eg: If your salary is Rs 30 lakh per annum, you can get a deduction on your own contribution up to Rs 1.5 lakh.

  • You get an additional deduction of Rs 50,000 for your own contribution.

So, in the example mentioned above, you can get an NPS deduction of Rs 3 lakh + Rs 1.5 lakh + Rs 50,000. This comes to Rs 5 lakh on your salary of Rs 30 lakh.

If you are self-employed

  • You get a deduction on NPS contributions up to a 20% of your gross income and subject to the ceiling of Rs 1.5 lakh.
  • You get an additional deduction of Rs 50,000 on your NPS contributions.

Eg: If you have an income of Rs 30 lakh from your business, you can get a deduction of NPS contributions up to Rs 2 lakh.

NPS Tier II Account

Tier II account is a voluntary account with flexible withdrawal and exit rules. Even though it works exactly like your NPS Tier I account, there are certain differences as below:

  1. It has no tax benefits. There is no tax deduction on contributions and the returns earned on the Tier II account are fully taxable (at the tax slab rates). 
  2. It has no lock-in. You can invest in the Tier II account and withdraw from it at any time.

However, like its Tier I counterpart, the Tier II account has very low management costs.

The Tier II account can only be opened alongside a Tier I account. If you close your Tier I account, your Tier II account is also automatically closed. 

You can choose your allocation between equities, corporate bonds and government bonds in the Tier II account or leave it in a lifecycle fund which decides this based on your age. Read about how to make this choice below.

You can also choose who manages your money. There are eight Pension Fund Managers to choose from. You can also change your selection up to once a year.

What is the best NPS Plan?

You have to make two major choices in the NPS.

Chose an asset allocation

Here you have to choose how to split your money between equities, corporate bonds and government bonds. You can either do this manually (called active-choice) or pick an NPS lifecycle fund (called auto-choice). You can also alter your choice up to twice a year.

Active Choice

In this option, you are free to choose any allocation between the three asset classes. Eg: 40, 30, 30 or 20, 50, 30. However, your equity allocation is capped at 50%. This allocation remains constant until the NPS corpus matures or you change the allocation yourself.

Auto-choice

Here, you can choose an NPS lifecycle fund. There are three available – conservative, moderate and aggressive. These split your money based on the NPS asset classes based on your age and begin at 25%, 50% and 75% in equity respectively. They progressively reduce this allocation and the allocation to corporate bonds in favour of safer government bonds as you age.

A smart plan for allocation

Pick the NPS Aggressive Lifecycle fund if you are aged 35 or below. This will allow you to have the maximum equity allocation permitted under the NPS and benefit from the growth in equity over the long term. The fund will automatically reduce your allocation to 50% as you age.

At age 41, your equity allocation will be just above 50%. At this point, switch to the ‘Active Choice.’ Leave this constant until the corpus matures at the age of 60. You will have given your money a fighting chance to grow to as large a size as possible.

This plan is a relatively aggressive one and equity markets can go down as well as up. However, retirement can stretch for a long time – 20 to 30 years and you are unlikely to need all your money at once. A 50% allocation to debt will give you sufficient cushion to take an income from even if the markets are in a bearish phase. It allows you to wait for the market to recover. There is no guarantee that markets will recover but some risk is essential if you want to accumulate a decent level of retirement savings.

Picking the best NPS fund manager

There are eight fund management companies in the NPS.

  • ICICI Prudential Pension Fund 
  • LIC Pension Fund 
  • Kotak Mahindra Pension Fund 
  • Reliance Capital Pension Fund
  • SBI Pension Fund
  • UTI Retirement Solutions Pension Fund LIC Pension Fund 
  • HDFC Pension Management Company 
  • Pension fund of Birla Sunlife Insurance

Until recently their investments were highly constrained by PFRDA guidelines leaving little room for differentiation among them. However, this was progressively changed in 2014 and 2015 and the returns diverged to a small extent in the past 1-2 years. 

Annuities

An annuity is a fixed sum of money that you receive every year, for your lifetime. An annuity is ‘purchased’ by paying a lump sum to the seller, usually an insurance company.

Eg: You pay Rs 10 lakh to an insurance company for an annuity of Rs 80,000 per year for the rest of your life.

An annuity is thus essentially a bet on your life – the longer you live, the more you get for your lump sum purchase.

There are many kinds of annuities. Some annuities make payments to your spouse after your death for the rest of his or her life. Others return your purchase lump sum to your heirs, once you pass away (diluting its nature from being a simple bet on your life). However, the more ‘favourable’ the features of an annuity, lower is the annuity rate given to you.

You are required to use at least 40% of your NPS corpus to purchase an annuity. You do not have to buy it from your pension fund manager or its affiliated company. In fact, it makes sense to compare annuity rates offered by different providers and select the best deal.

To find the latest annuity figures go to https://npscra.nsdl.co.in/annuity-service-providers.php

What are NPS Lifecycle Funds?

Lifecycle funds under the NPS are funds which automatically split your pension corpus into three classes – equity, corporate bonds and government bonds, based on your age.

As the table below shows, all three lifecycle funds have a fixed allocation until the age of 35 and then start changing them every year. This process continues until you hit the age of 55 and the allocation once again becomes fixed.

The Aggressive Lifecycle Fund starts out with 75% allocation to equity, 10% to corporate bonds and 15% to government bonds. It ends at 15% to equity, 10% to corporate bonds and 75% to government bonds.

The Conservative Lifecycle Fund is a kind of mirror image of the Aggressive Fund. It begins at 25-45-30 between Equity, Corporate Bonds and Government bonds and moves towards 5-5-90.

The Moderate Lifecycle Fund is the ‘default’ lifecycle fund if you fail to make a choice or have entered the NPS before the Aggressive and Conservative Funds were introduced and picked the ‘Auto-choice’ option. It begins with a 50-30-20 split between equity, corporate bonds and government bonds and ends with 10-10-80.

You can switch from the lifecycle funds to ‘Active Choice’ in which you choose the allocation. This can be done at most twice per year.

Aggressive Conservative Moderate
Age E C G E C G E C G
Upto 35 years 75% 10% 15% 25% 45% 30% 50% 30% 20%
36 71% 11% 18% 24% 43% 33% 48% 29% 23%
37 67% 12% 21% 23% 41% 36% 46% 28% 26%
38 63% 13% 24% 22% 39% 39% 44% 27% 29%
39 59% 14% 27% 21% 37% 42% 42% 26% 32%
40 55% 15% 30% 20% 35% 45% 40% 25% 35%
41 51% 16% 33% 19% 33% 48% 38% 24% 38%
42 47% 17% 36% 18% 31% 51% 36% 23% 41%
43 43% 18% 39% 17% 29% 54% 34% 22% 44%
44 39% 19% 42% 16% 27% 57% 32% 21% 47%
45 35% 20% 45% 15% 25% 60% 30% 20% 50%
46 32% 20% 48% 14% 23% 63% 28% 19% 53%
47 29% 20% 51% 13% 21% 66% 26% 18% 56%
48 26% 20% 54% 12% 19% 69% 24% 17% 59%
49 23% 20% 57% 11% 17% 72% 22% 16% 62%
50 20% 20% 60% 10% 15% 75% 20% 15% 65%
51 19% 18% 63% 9% 13% 78% 18% 14% 68%
52 18% 16% 66% 8% 11% 81% 16% 13% 71%
53 17% 14% 69% 7% 9% 84% 14% 12% 74%
54 16% 12% 72% 6% 7% 87% 12% 11% 77%
55 15% 10% 75% 5% 5% 90% 10% 10% 80%
Asset Class E = Equity C= Corporate Bonds G= Government Bonds

Withdrawals from the NPS

  1. On Maturity

The NPS corpus matures at the age of 60. Upon maturity, you can withdraw 40% of your corpus as a tax-free lump sum. You must use another 40% to purchase an annuity. The balance 20%, you can either use to purchase an annuity or withdraw after paying tax.

  1. Premature Exit

However, you can withdraw from the NPS before the age of maturity as well. This is termed as ‘premature exit’ and upon such a withdrawal, 80% of your corpus must compulsorily be used to purchase an annuity. The remaining 20% can be withdrawn but is a taxable sum.

  1. Partial Withdrawal

You can also make ‘partial’ withdrawals up to 25% of your NPS contributions after three years of joining the NPS on specified grounds. These withdrawals will be tax-free. These are a home purchase, construction, children’s education, children’s marriage and the treatment of a critical illness for self, spouse, children or dependent parents. 

If you join the NPS after the age of 60, your corpus can be withdrawn as a maturity amount after a holding period of three years. You can withdraw before this time period also but this would be deemed as a premature exit and hence you would have to use 80% of your corpus to buy an annuity. The balance 20% can be withdrawn as a lump sum after paying tax.

Opening an NPS account

NPS is distributed through several authorised entities called Points of Presence (POPs) which include banks (both private and public sector) and certain financial institutions. You can also open NPS account online through National Pension Trust.

Author
Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.