- February 29, 2016
- Category: Product Analysis
The National Pension Scheme (NPS) is a government backed defined contribution retirement product. The objective of NPS is to provide a pension plan to the ageing population of the country. The returns are not guaranteed and linked to markets unlike the traditional pension products. Presently, what is luring investors to consider investment in NPS is the additional tax incentive of Rs.50,000 available under section 80 CCD (1B). This is over and above the Rs.1.5 lakh deduction available under S/80 C. The basic features of NPS are explained in the mind map above.
The problems with NPS:
While the additional tax incentive is a big plus point, NPS has its share of issues. The taxability on a huge 60 per cent of the withdrawable corpus at retirement is a big put-off for investors. Also, there is some ambiguity related to few tax issues. Further, withdrawal rules are not flexible enough and low liquidity is a concern. Let us examine these issues:
|NPS Withdrawal & Exit Rules|
|At the age of 60||For all amounts above Rs.2 lakh, at least 40% of the corpus to be used for purchase of annuity|
|Remaining amount to be paid as lump sum|
|Option to delay purchase of compulsory annuity by up to 3 years|
|Option to delay withdrawal of lump sum amount till the age of 70|
|Option to make fresh contributions till the age of 70 (Not for govt employees)|
|Voluntary retirement||NPS subscription for minimum 10 years to be eligible for early exit|
|For all amounts above Rs.1 lakh, at least 80% of the corpus to be used for purchase of annuity|
|Remaining amount to be paid as lump sum|
|Premature Death||For Government employee|
|For all amounts above Rs.2 lakh, at least 40% of the corpus to be used for purchase of annuity|
|Remaining amount to be paid as lump sum to nominee/legal heir|
|For Private employee|
|Option to withdraw entire accumulated corpus by nominee/legal heir|
|Purchase of annuity optional|
|Partial interim Withdrawal||NPS subscription for minimum 10 years to be eligible for partial interim withdrawal|
|25% of employee contribution to NPS is the maximum withdrawal limit|
|Allowed up to a maximum of 3 times during the entire subscription period|
|Minimum 5 years gap between 2 withdrawals (except for treatment of illnesses)|
|Can withdraw for children education & marriage, purchase of house or treatment of specified diseases for self & dependants|
- Rigid exit and withdrawal rules:
(1) At the age of 60: With people marrying late and starting a family in their 30s nowadays, their financial responsibilities may well not be over at 60. In such a case, the withdrawal rules of NPS are not flexible enough to provide a retiree control over his own money. He has to lock a minimum 40% of the corpus in compulsory annuity. There are numerous annuity products available in the market and a retiree can buy those of any amount in the future if he wishes to rather than locking his money through NPS. With people marrying late and starting a family in their 30s nowadays, their financial responsibilities may well not be over at 60. In such a case, the withdrawal rules of NPS are not flexible enough to provide a retiree control over his own money. He has to lock a minimum 40% of the corpus in compulsory annuity. There are numerous annuity products available in the market and a retiree can buy those of any amount in the future if he wishes to rather than locking his money through NPS.
(2) Voluntary retirement: Imagine an employee who takes voluntary retirement before 60 and desires to start his business. He is banking on his NPS savings to invest in the venture. But he cannot withdraw, as a very substantial 80 per cent of the NPS corpus gets locked into annuity if he retires before 60.
(3) Death before maturity of NPS: In the event of premature death, for a government employee, 40% of the money gets locked into compulsory annuity while in the case of a private employee, it is optional. There is no logic here in keeping the exit rules different between government and private employees. The nominee/legal heirs of a government employee may require money as much as those of a private employee may do after their demise.
- Taxation: The tax treatment of the NPS corpus is a big spoiler when compared to other retirement products like EPF, PPF, etc. The recent amendment in the Union Budget (2016-17) has proposed some tax relief but is not enough. Earlier, the entire 100 per cent amount to be withdrawn at 60 was declared taxable. Now, of the maximum 60 per cent accumulated corpus withdrawable at the time of maturity, about 60 per cent will be taxed as per individual’s slab rate. The balance 40 per cent will be tax free. It is unfair that such a substantial lump sum is treated as income unlike debt mutual funds where capital gains are computed and indexation benefit is available on them.
Further, while the amount converted to annuity will not be taxed, the annuity income received in the future years is taxable in the hands of the investor as per the slab rate. The tax treatment is the same on pre-mature exit from NPS, i.e., before retirement.
These taxation rules apply to private sector employees who open an NPS account with their employer. They also apply to the self employed who individually open their NPS accounts. For government employees, the lump sum withdrawal at the time of retirement is tax free. The tax treatment is thus unfair and does not offer uniform treatment to all participants.
Ambiguity on tax issues:There is no clarity on the tax treatment of partial withdrawals from NPS which are allowed up to a maximum of 25% of an investor’s contribution thrice during the entire subscription period.
Also, there is no clarity on whether section 10(10A) will be applicable to NPS or not. This section covers commuted pension which is received lump sum at the time of retirement. Under this section, if a private sector employee gets gratuity at the time of retirement, 1/3rd of the commuted pension will be tax free. If the employee does not receive gratuity, one-half of the commuted pension will be tax free. This section if applicable can bring substantial tax relief to investors.
- Limited equity exposure:NPS invests your money in 3 instruments – equity, government securities and other fixed income options. As per the recent revised guidelines, fund managers under NPS can actively manage money not just by investing in stocks but also mutual funds, exchange traded funds and IPOs. NPS however allows limited exposure to equity. Pure mutual funds are likely to provide better returns than NPS in the long run.
For private sector employees investing in NPS, equity exposure is capped at 50 per cent and for government employees, it is 15 per cent. The difference in equity cap for both sectors is ridiculous. Government employees have been thrust upon a product (Yes! Compulsory for employees joining after 1.1.2004) which does not allow them the freedom to choose their own asset allocation and they have to make do with a lower equity exposure and compromise on returns.
Conclusion: If you are a beginner who wants to take exposure to equities but have no clue how to go about it, you can consider investing in NPS. For salaried employees, it would instill discipline to save compulsorily just like the EPF contributions get deducted every month. NPS is a true retirement product, with strict restrictions on withdrawals during the accumulation period.
If you already have exposure to equities and are a disciplined investor who allocates a portion of his savings every month into equities, you are better off not investing in NPS. NPS is basically a tax deferral product. You would be availing the additional Rs.50,000 tax benefit now only to pay tax later at retirement. And, not just on the gains. You would be paying 60 per cent tax on a substantial 60 per cent of your hard earned savings eligible for withdrawal at retirement. It is prudent to pay tax now and invest the rest in equity funds. You would earn better returns and have complete control on the management of your retirement corpus.