Should you invest in NPS? And the irony of it. [Feb 2020]

Finance For Beginners

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 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 about:

  • 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

  • It’s a product designed specifically with retirement 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 operate like mutual funds.
  • Investment matures when you’re sixty years old.
  • Some partial withdrawals are allowed. But the entire product is primarily designed to ensure maximum lock-in.

Should you invest in NPS: Tax implications

For the amount that you are contributing to your NPS:

  • Your investment(up to 10% of your salary) is deductible under section 80C.
  • But for NPS, you can contribute an additional 50,000, and claim it as a deduction as well. [under section 80CCD(1)]

For the amount that your employer is contributing to your NPS:

  • Like in EPF, your employer can also contribute towards your NPS.
  • If your employer is also contributing to your NPS, their contribution will be exempt until a maximum of 10% of basic salary (Under Section 80CCD(2))

Should you invest in NPS Tier-2 account?

What’s the difference between a Tier-1 and Tier-2 account anyway?

If you consider the way they operate, then there’s no difference.

  • A Tier-2 account is something you open if you want to invest more into your retirement planning and want to use NPS for it.
  • 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, it has no lock-ins either.

Should you invest in NPS: Difference between Active and Auto

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: Withdrawal

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: The Downsides

  • Very low liquidity; most of your money stays locked up and unavailable to you during the duration – but that was the very intention behind the design of the product.
  • 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.

Should you invest in NPS? Final recommendations

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 lack an understanding of finances

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 understand finances reasonably well

Avoid NPS.

  • You may not like the extremely long lock-ins and the lack of flexibility.
  • You can avoid the extremely long lockins and manage your asset allocation using a combination of other 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 discussed 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 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.

Attend a live program and understand finances better

Logo Black Transparent - The Moneyplanting Program on Financial Wellness

The Moneyplanting Program is conducted as a corporate training program and is available through your employer.

Check with your HR for upcoming scheduled sessions.


And that concludes the topic of NPS.

Happy Moneyplanting.


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