Things you didn't know about NPS

'I am done with my 80C and 80D tax savings for the year. But still paying lot of tax.' Said Monisha, a 31 years old Software professional to her colleagues Akshay and Neha.

Neha: Me too !! Is there a way out ?

Monisha: Of course NPS !! I have heard from many people that it is the best tax saving option beyond 80C. It is covered under a separate limit of Rs. 50,000 u/s 80CCD. Isn't that right Akshay?

Akshay (smiling): Well not really. I would prefer not going for NPS. Are you aware of a few things about NPS ?

Neha (Curiously): Like?

Akshay: First of all, it is not a tax saving scheme. It is more of a tax deferment scheme.

Monisha: What's a tax deferment scheme now? Please explain in simple terms. We are not finance experts.

Akshay: I will explain with a simple example. Suppose you make an FD of Rs. 1 Lakh with 7% interest for one year. How much income will be taxable after 1 year?

Monisha: This is easy. I will pay tax on Rs. 7000 which is the interest earned on my original 1 Lakh.

Akshay : How would you like to pay a tax on entire Rs. 1.07 Lakh ?

Monisha : That would be so unfair. I should be taxed only on the income. If possible, that income should also be tax free.

Akshay: Correct. But unfortunately, in an NPS, you have to pay tax on the withdrawal amount (not on gains). Suppose you invest Rs. 50,000 in NPS for lets say 20 years, you have total Rs. 10 Lakhs accumulated as your contribution.

Lets assume, this amount grows to around Rs. 17 Lakhs (assumption as there is no fixed return defined in NPS), only 40% is tax free that too if withdrawn after the age of 60.

So in this case, only Rs. 6.80 lakhs can be withdrawn as tax free. Remaining amount needs to be used to purchase annuity. Also, the returns coming from this annuity are poor and also taxable.

So, if you wish to withdraw entire Rs. 17 Lakhs, you have only Rs. 6.8 lakhs tax free. Out of the remaining Rs. 3.20 Lakhs which was your principle, is also taxable. So you are not really “saving tax”. You are just deferring it by few years.

Neha: Oh No !! That's really bad. I would though want my returns also tax free. Who will pay tax on principle also!!

Monisha : But tell me something !! Isn't 'deferring tax' a good idea ? At least I am not required to pay tax today.

Akshay: That depends on your perspective. The way I would look at it, today I am earning. So I can still afford to pay tax. At my retirement, my earning would stop. So paying a big tax at that time would be a bad idea for me.

Neha: Apart from this, are there any other reasons for you not to invest in NPS ?

Akshay : Yes, few more actually. One major reason is passive fund management. NPS doesn't have an active fund manager like an ELSS or diversified mutual fund. It replicates an index. I believe that in India, we still have lot of potential for higher returns through active fund management. I would not like to go for passive fund management.

Moreover, it has a highest equity exposure of 50% even if you go for an active choice. Now, if my time horizon is more than 15 years, why should I have such a low equity exposure?

Another reason is liquidity. If I need money in midway, I can withdraw only 25% of my contribution (not total fund value). That too is subject to following conditions:

• The Partial withdrawal shall be allowed for specific purposes such as higher education of children, marriage of children, purchase or construction of residential house or for treatment of specified diseases.

• Individual should have subscribed to NPS for at least 10 years.

• Maximum of 3 withdrawals during the entire tenure are allowed.

• Minimum gap of 5 years is required between the two withdrawals. However, this condition shall not apply in case of withdrawal for treatment of specified illness.

Neha : Indeed. These don't really sound great.

Monisha: No No!! This is wrong!! NPS amount can be withdrawn freely.

Akshay : What you are talking about is Tier 2 Account of NPS. It has relaxations on contributions and withdrawals. But then, contribution to Tier 2 are also not eligible for “tax saving” u/s 80CCD.

Only Tier 1 Contributions qualify u/s 80CCD and there are all the above restrictions applicable on them.

Neha : What's the use then ? Tier 2 is like any other non-tax-saving investment.

Akshay : Lastly, its not a big reason, but one of the negative factors which I dislike about NPS is compulsory contribution. I have to mandatorily contribute Rs. 6000 p.a. to NPS once I open it. That's not a very big amount, but still that compulsion doesn't look too comfortable to me.

Neha : Right. So if we do not invest in NPS, we have to pay tax on that income. That would be worth it?

Akshay : Lets look at the whole thing in totality. If we are in a 20% tax slab, we would “save” Rs. 10,000 as tax by putting Rs. 50,000 in NPS today.

Ultimately, we will have to pay tax on it during our retirement.

Also, this amount will have lower growth as it has lower equity allocation and passive fund management.

Plus, I have lot of restrictions on withdrawals and compulsions on contributions.

I would rather pay Rs. 10,000 as tax and invest Rs. 40,000 in an actively managed diversified equity fund, which would give me higher returns, tax free and plus no compulsions to pay every year. Also, in case I want, I can withdraw the entire fund value.

Over a 20 years period, I am expected to get at least Rs. 6-7 lakhs more by investing in a diversified mutual fund (even after paying the tax).

Over a 30 years period, this difference can increase upto the extent of Rs. 20 lakhs even if I am in the 30% tax slab (i.e. even after paying Rs. 15000 as tax for 30 years).

Neha : Oh My God !! I have more than 30 years to retire. For me the difference will be even more than Rs. 20 Lakhs if I go with diversified equity MF instead of NPS.

Monisha : Sounds Logical. So none of us should invest in NPS right?

Akshay: Well Neha, Monisha, I am not an expert to be giving you any opinion for you. Whatever, I have told you is what I have been discussing with my financial advisor. What is right for me, may not be exactly right for you. Monisha is 31, married and has one child. Neha is 27 and single. So the planning for all of us could differ. The best would be take professional help without any delay.

Neha, Monisha: Thanks for the useful info Akshay. Our doubts about NPS are also clear. And now we also understand that tax planning works best when we look at it in totality and it is in line with our financial planning.

We look forward to your feedback and comments on the above article.

The Author Prof. Saurabh Bajaj (BE, MBA, FRM, CFGP) is CEO with Nidhi Investments, Mumbai. He can also be reached at CEO@nidhiinvestments.com.

(The views mentioned in the article are personal opinion of the author. The characters used in the article are hypothetical).