Understanding the National Pension Scheme: A Beginner’s Guide
Some investments are meant to be done for the long-term. One financial goal common to all people is retirement. We must save adequately for our golden years when we’ll no longer have financially productive full-time employment. We’ll need to fall back on our long-term investments to help generate the income which will keep us going through our old age.
BY ADHIL SHETTY
Some investments are meant to be done for the long-term. One financial goal common to all people is retirement. We must save adequately for our golden years when we’ll no longer have financially productive full-time employment. We’ll need to fall back on our long-term investments to help generate the income which will keep us going through our old age.
One such long-term investment option is the National Pension Scheme. It allows you to invest in schemes that combine equity with corporate and government debt securities. The NPS also provides tax deductions under Section 80 of the Income Tax Act.
WHAT IS THE NATIONAL PENSION SCHEME?
The National Pension Scheme was launched by the government to help Indians save for retirement. The scheme also offers secondary benefits which include a market-based return on investment over a period of time, as well as tax deductions and exemption under various sections of the Income Tax Act.
The scheme is based on the Permanent Retirement Account Number (PRAN) which is given to each person when they subscribe to the National Pension Scheme. With the money accumulated in the scheme during the work tenure of the individual, investors can make a partial tax-free withdrawal on retirement and must compulsorily invest the rest in an annuity plan.
ELIGIBILITY CRITERIA FOR NPS
Anyone who is a citizen of India, non-resident or resident can join the National Pension Scheme. However, there are certain rules and regulations. The applicant must be between the age of 18-65 years on the date of application submission.
The National Pension Scheme will not be applicable for Hindu Undivided Families, Person of Indian Origin and Overseas Citizen of India. The applicant must also comply with the KYC norms as mentioned in the submission form.
Undischarged insolvents, pre-existing account holders under NPS and individuals who are not of sound mind cannot join the National Pension Scheme.
STEPS TO REGISTER FOR THE NATIONAL PENSION SCHEME
Any person who is eligible to join the National Pension Scheme can register for the NPS through two methods which include either visiting the Point of Presence – Service Providers (POP-SP) or through eNPS.
There are mainly two types of accounts one can create under the National Pension Scheme which are Tier I and Tier II accounts. The Tier I account is a pension account which is the mandatory account which must be opened to join the National Pension Scheme. However, the Tier II account is an investment account which can be opened at any time, either while registering or later.
A Tier I account requires a minimum contribution of Rs.1,000 per year and redemption is only allowed at 60 years of age or after 10 years from the date of opening. On the other hand, for a Tier II account, there is no minimum contribution to be made per year and the money deposited in the account can be redeemed at any time.
HOW TO INVEST IN THE NATIONAL PENSION SCHEME
If a person has opened a Tier I account under the National Pension Scheme, they will be required to deposit Rs.1,000 per year at the minimum. The major reason why people invest in this scheme to avail tax benefits and have a sufficient pool of money post-retirement.
With the National Pension Scheme, you can avail a tax benefit of Rs.1.5 lakh under the Section 80C of the Income Tax Act. Along with this, an additional tax benefit of Rs.50,000 is given under 80CCD. If a person comes under the 30% tax bracket, he or she can save up to Rs.15,600 per year.
Once you receive the PRAN, you will have an option to invest in the scheme. The National Pension Scheme will provide you with a wide range of investment choices along with a fund manager. There are eight fund managers such as HDFC Pension Management, UTI Retirement Solutions, and Reliance Capital Pension Fund Limited.
CHOICE OF INVESTMENT – EQUITY & DEBT
When it comes to investment choice, you can either choose an active choice or an auto choice. With the active choice, you will have the power to create your own portfolio which will include equity, government securities and corporate bonds. However, with the auto choice, a fund manager will be creating the portfolio for you which will include all the components with the percentage of investment in each asset category will be pre-decided. The key to investing in the National Pension Scheme is to not look at it as a means to avail tax benefits, but rather to build a retirement fund.
RETURNS AND RISKS OF THE NATIONAL PENSION SCHEME
There are a number of risks when it comes to the National Pension Scheme and moreover its complexity tends to get in the way of a great investment opportunity. There has been an extensive study on why investors often refrain from the National Pension Scheme. Some of the reasons why the NPS is a risky investment instrument are:
The NPS corpus on maturity is only 60% tax-free: On maturity, you can withdraw 60% of your NPS corpus, tax-free. The other 40% has to be invested compulsorily in an annuity plan. This doesn’t compare favourably with PPF or EPF. Also, your annuity income through pension would be taxable as per your slab.
Withdrawals are not allowed until the age of 60: Even though in a way locking a certain amount of money for this long a period can be a good decision, every investor has a set of financial goals in place. If a particular financial goal turns out to be more important before the age of 60, withdrawing funds from the NPS would be beneficial. However, since this is not the case, investors often choose from other options such as equity or mutual Funds which allows withdrawals at any time.
Investment on equities limited to 75%: Some of the most lucrative, high-risk investments are equities. Hence, the younger generation who are often more aggressive in terms of their investments prefers to invest in equities.
However, with the NPS capping the limit of equity investment between 50% and 75% can be highly restrictive.
No assurance on returns: The National Pension Scheme is dependent on market-linked instruments such as equities. Even the value of corporate and government bonds can react to macroeconomic developments. Hence NPS returns are not guaranteed.
WITHDRAWAL AND TAXATION OF RETURNS
An investor in the National Pension Scheme can exit after 10 years from the date of opening the account or directly after he or she has reached the age of 60.
If a person is exiting after 10 years and before the age of 60, 20% of the corpus can be redeemed and 80% of the balance will be invested in the annuity. However, if the corpus is less than or equal to Rs.1 lakh the entire amount can be withdrawn.
On the other hand, if an investor wishes to exit after the retirement age of 60, only 60% of the corpus can be redeemed as lump sum and the rest 40% must be invested in the annuity. If the corpus is less than or equal to Rs.2 lakh, the total sum can be withdrawn.
PARTIAL WITHDRAWAL AND DEATH BENEFITS
In the case of death of the investor, the claim to the corpus amount will fall on the nominee or legal heir of the investor.
The National Pension Scheme also offers the facility of partial withdrawal where in the entire lifetime, the investor is entitled to three partial withdrawals from the Tier I account before reaching 60 years of age. The first partial withdrawal can be done three years after the account is opened, and the second and third partial withdrawal can be made any time after.
TAXATION OF RETURNS
The National Pension Scheme allows on 60% of the corpus withdrawn in lumpsum will be exempted from tax. The rest 40% of the corpus which will be invested in the annuity will also be free from tax, but the pension income will be taxed as per the investor’s slab. This will only be applicable for the funds deposited in Tier I accounts.
PROS AND CONS OF THE NATIONAL PENSION SCHEME
Like every other investment instrument, the National Pension Scheme has its set of pros and cons. The list of pros of the NPS are a range of schemes to choose from, convenience, and diversification.
However, the cons of the NPS are limits on withdrawal including the 60% limit on maturity, and the capping of equity investments at 50-75%. The National Pension Scheme offers an array of investment opportunities in terms of asset allocation. Hence the earlier one starts investing in the NPS, the lesser his or her tax liability will be at retirement.
The writer is CEO, BankBazaar.com, India’s leading online marketplace for loans, credit cards, credit trackers, and more.