Should you invest in NPS?
This post takes a look at how NPS works, its options and whether you should invest in it. The whole post is in sections and bulleted points so just skip the parts you think you already know.
THE IRONY OF NPS
NPS (National Pension Scheme) is a retirement product created keeping in mind the needs of the masses — especially those who lack an adequate knowledge of finances.
But — to understand NPS well, one needs to know quite a lot about finances. As a matter of fact, if you decide to understand NPS from scratch, you’ll pretty much be able to understand the entire investment landscape.
Why? Because you’ll need to know the fundamentals of:
- Stocks (Equities and their risks)
- Debt (Fixed income products)
- Government Debt
- Corporate Debt
- Annuities
- Taxation (deductions, exemptions, tax brackets)
- Mutual funds
- Salary structure
- Asset allocation
- Other retirement focused products like PPF, VPF, EPF etc.
SHOULD YOU INVEST IN NPS:
THE BASICS
- NPS a product designed specifically with a person’s retirement pension in mind.
- Is a combination of a bank account you can’t easily withdraw out of, and a mutual fund.
- You open an account like you would in a bank, and then invest into products which function like mutual funds.
- These funds could either be Debt-based(Debt products are designed to protect your money, but not grow it), or Equity-based(which is primarily is designed to grow your money at higher risk)
- NPS matures when you’re sixty years old. Basically, most benefits of NPS can only be availed once you’re past your sixties.
- Some partial withdrawals are allowed. But the entire product is primarily designed to ensure maximum lock-in – which means your money won’t be available to you when you need.
SHOULD YOU INVEST IN NPS:
TAX SAVING ASPECTS
Most folks start to consider investing in NPS due to its additional tax benefits. Both you and your employer can contribute towards your NPS.
For the amount that You are contributing to your NPS:
- Your investment(up to 10% of your salary) is tax deductible under section 80C.
- You can contribute an additional 50,000, and claim it as a deduction as well. [under section 80CCD(1)]
- If you decide to contribute more than what’s allowed in these two, you can. This is done with the help of a Tier-2 account. However, there are no tax-benefits of investing in a Tier-2 account.
For the amount that Your Employer is contributing to your NPS:
- Like in EPF, your employer can also contribute towards your NPS.
- Your employer’s contribution will be exempt until a maximum of 10% of basic salary (Under Section 80CCD(2))
SHOULD YOU INVEST IN NPS:
WHERE DOES YOUR MONEY IN NPS GO?
The amount you invest in NPS is managed in instruments called Pension funds.
There are about 8 pension funds as of today. And they are managed by firms like SBI, ICICI, UTI, LIC, HDFC etc. The pension fund manager options are different depending upon whether you are employed by the government, or by a private firm.
You have the option to choose between various pension fund managers, which adds another layer of complexity to an already complicated product.
SHOULD YOU INVEST IN NPS:
TYPES OF ACCOUNTS WITHIN AN NPS
By default, when you open an NPS account, you open what’s called as a Tier-1 account. But there’s also something called a Tier-2 account.
What’s the difference between a NPS Tier-1 and Tier-2 account ?
If you consider the way they operate, or the way they invest your money, there’s no difference.
- A Tier-2 account is something you open if you want to invest more into your NPS.
- It can only be opened once you already have a Tier-1 account.
- The key difference is that a Tier-2 account has no tax benefits whatsoever – either when you’re contributing or when you’re withdrawing.
- At the same time, Tier-2 has no lock-ins either.
SHOULD YOU INVEST IN NPS:
THE AUTO & ACTIVE OPTIONS
Within a Tier-1 or Tier-2 account, you’ll need to decide between Auto mode and Active mode.
Active-choice
- In active, you can select between debt and equity.
- You basically decide how much of your contribution goes to equities and how much to Debt (You chose between Equities(E), Government bonds(G), Corporate bonds(B) and Alternate Assets(A))
- Maximum allocation to equity is limited to 75%.
- You need to decide a fund manager from a list of 7 or 8. HDFC, UTI & ICICI are currently doing better among them.
Auto-choice
- In auto-choice, the allocation between equities and debt is automatically adjusted as you age.
- Your debt allocation is slowly increased and equity allocation is slowly reduced.
- Until 30s, you’ll have about 20% exposure to debt.
You can switch between the two choices twice a year, for free.
SHOULD YOU INVEST IN NPS:
HOW IS NPS WITHDRAWAL TAXED
If you withdraw once you’re 60 years old
- 60% of the corpus can be withdrawn as a lump sum amount. This is tax-free.
- Remaining 40% mandatorily needs to be invested in a low-interest annuity product. This will provide you monthly income and will be taxable as per your tax-slab then.
If you decide to withdraw before 60
- Only 20% can be withdrawn. And you will be taxed as per your slab.
- The remaining 80% will be stuck in annuities.
Are partial withdrawals allowed in NPS?
- Yes. You are allowed to withdraw 25% of contribution after three years for ‘defined expenses’ – things like children’s higher education, weddings, construction of first house, medical emergencies etc.
- About 3 withdrawals are allowed during the entire tenure.
SHOULD YOU INVEST IN NPS:
ALL THE DOWNSIDES
- The low liquidity. This means that most of your money stays locked up and unavailable to you during until you reach the age of 60.
- Forced annuity investment of 40% of corpus is bad. This is taxable at your end. Annuities provide low, to very low returns. But again, this was designed to provide you with a monthly income source.
- Complexity. It’s hard to think of any other retail investment product in India which is as complicated as NPS.
SHOULD YOU INVEST IN NPS:
REVIEW & RECOMMENDATION
If you are in your 20s
Avoid NPS like the plague.
- There is absolutely no reason why you should have your money stuck in an investment product so long, since most benefits of NPS are only available once your 60.
- You may need access your cash to start a new venture, for higher education, or for your wedding.
- Even if none of that is true, you’re still looking at locking up your investment for a staggering 40 years.
If you are in your 30s, and do not plan to ever learn about personal finances & investing:
Take up NPS with the Auto option.
- It absolves you from the burden of learning about finances, while ensuring you are still saving for retirement.
- Auto option will ensure balancing between growing your money and protecting your money will happen automatically – which is again one less thing you’ll need to understand.
If you are aged 30 or more, and plan to improve your financial literacy:
Avoid NPS.
- Once you build the needed fundamentals, you will absolutely not like the extremely long lock-ins and the lack of flexibility.
- You can avoid these long lock-ins and manage your asset allocation using a combination of other simpler, more effective products.
- You’ll also not have a massive 40% of your corpus stuck in annuities when you retire.
If you are aged 30 or more, and understand finances very well
You can consider taking up the NPS Active option – for a hidden, rarely understood reason.
- Since you probably also understand interest rate scenario changes, and know when the markets are overweight, you might be the type who alters asset allocations often.
- And in NPS, you’ll be able to switch back and forth between equities and debt at zero cost. If you tried switch between Debt and Equities in other investments, you’ll end up paying a lot in capital gains taxes.
- But NPS will allow you to balance your asset allocation without the tax overheads.
- Because of the same reason, even a Tier-2 option will make sense for you.
If you are aged 45 or more, and don’t understand finances well
Take up NPS Auto option.
Why?
- Within just 15 years you’ll have access to your corpus. That’s still a considerably long lock-in, but not as bad as being in your 20s.
- You’re closer to retirement so getting a fixed monthly income from annuities wouldn’t a terrible thing.
If you are aged 45 or more, and have accumulated reasonable wealth
Take up NPS Active option and allocate 50-70% to equities.
Why?
- Within just 15 years you’ll have access to your corpus.
- Not to mention the fact that you’ll be investing in a product with low management costs
- You’re closer to retirement so getting a fixed monthly income from annuities wouldn’t a terrible thing.
- Since you have accumulated other assets already which will help you live reasonably well once you’ve retired, it’s ok to take the risk of equities with NPS. If you’re 45, you’re still looking at 15 years of equity exposure.
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I understand how complicated this post is. But that’s mostly due to the fact that NPS in itself, is rather complicated.
If you’d like to understand more about Investing in general so you can invest better, give this book a try. It should give you an easy 10-year head start on your knowledge of finances.
And that concludes the topic of NPS. Have a good weekend.
Vinod
A beginner’s book on investing unlike any other
Learn everything a working adult needs to know about money and investing
From bare bones fundamentals, and to a solid 10-year head start. All taught in a way never taught before.