India’s National Pension System (NPS) has undergone a dramatic overhaul over the past few days. Most of the changes apply to government employees but a key tax change applies to everyone – including private sector employees and the self-employed. This tax reform has made the NPS corpus, completely tax free on maturity, thereby making it a hugely attractive retirement option.
What is the NPS
The NPS or National Pension System is government backed retirement scheme. Your contributions in the NPS are invested in equity and debt funds in order to build up a retirement corpus over time. At the age of 60, you can this corpus (or a part of it) to buy an annuity (a monthly pension). Contributions to the NPS are tax deductible up to Rs 2 lakh per annum under Sections 80C and 80CCD(1B). The returns on the NPS are also tax-free so long as the money is not withdrawn. These provisions have not been changed.
However the tax-treatment of the NPS at maturity has changed. At maturity 40% of the corpus was tax-free. You had to use another 40% to buy an annuity (monthly pension), leaving the balance 20% as a taxable sum. According to a notification issued on 10th December, 2018, the government has increased the tax-free portion from 40% to 60%. Since the remaining 40% has to be used to buy an annuity (and is tax-free at the time of purchase), the entire NPS corpus at maturity becomes tax-free. Note however that the annuity is still taxable – your monthly pension will be added every year to your income and taxed. That said, the tax change has put the NPS ahead of most other retirement saving instruments in India.
If you are a Government Employee
The NPS is mandatory for government employees and hence the government has sweetened the deal for them a lot more than the private sector. The employer (government) and employee contributions were earlier set a 10% of monthly salary and dearness allowance. The Government has now hiked the its own contribution to 14%. If the government employee chooses to convert his entire NPS corpus into an annuity, he/she will be assured a pension at a minimum of 50% of last drawn salary. Government employees will be allowed to choose between 4 investment plans with 0%, 15%, 25% and 50% equity allocation respectively. This means that those with a strong risk appetite will be allowed to potentially build a large pension corpus through equity investment. Government employees will also be allowed to pick any one of the 8 fund managers in the NPS. Last but not least, the tax deduction has also been extended to NPS Tier II, an account which previously had no tax benefits. The only condition laid down for this account is a 3 year lock-in. This brings NPS Tier II, on par with hugely popular ELSS (tax saving) mutual funds. The current reforms apply to Central Government employees but will extend to State Government employees once individual states adopt them.
Why the NPS works for everyone
- The NPS allows you to invest in equity up to 75% of your corpus. Over the long term, equity can give returns of 12-15% allowing you to build a huge pension corpus in your lifetime.
- NPS has extremely low costs. Fund management fees are capped at just 0.01% of your corpus. Contrast this with the 2-2.5% charged for mutual funds and the 5-20% charged in the investment plans of insurance companies.
- All subscribers can choose any one of the 8 fund managers in the NPS and can shift between them in case of under performance.
- All subscribers can choose the break-up of equity, corporate bonds and government bonds in the NPS. Government subscribers can allocate up to 50% of their corpus to equity and private sector subscribers can allocate up to 75% of their corpus to equity.
- NPS has a lock-in till the age of 60. This protects you from withdrawing your money too early during market panics
- NPS has become an EEE (Exempt, Exempt, Exempt) instrument. It is tax-deductible at the time of contributions, has tax-free returns and is now tax-free on maturity.