Tax Saving Tuesday: NPS
A deep dive into the National Pension Scheme
Welcome to another edition of The Stable Investor.
Last week, we explored a popular tax-saving instrument, Public Provident Fund. Today we continue with the second instalment of Tax Saving Tuesdays with a breakdown of one of the most popular tax saving schemes, the National Pension Scheme (NPS).
A broad overview of NPS
The National Pension Scheme (NPS) is a voluntary, long-term retirement savings scheme designed to enable systematic savings for individuals. It was launched by the Government of India in January 2004 but has undergone several modifications since then.
NPS is a market linked, defined contribution product. This means that subscribers define how much to contribute and where to invest. NPS offers a range of investment options, including equity, corporate bonds, government securities, and alternative investment funds.
Subscribers can choose their asset allocation based on their risk appetite, while the more intricate details will be managed by a Pension Fund Manager of their choice.
Upon maturity of the investment, which happens when the subscriber reaches 60 years of age, investors must use at least 40% of the accumulated corpus to purchase an annuity, which provides a regular pension. The remaining 60% can be withdrawn as a lump sum.
While being a slightly complicated investment option, the NPS has some rather interesting aspects, some of which we will explore today.
Active-Choice and Auto-Choice
Arguably, the most intriguing part of NPS is the Active-Choice and Auto-Choice investment options.
Active-Choice
As suggested by the name, Active-Choice involves actively deciding the allocation of funds towards different asset classes. And while there are some restrictions on the percentage of funds that can be allocated towards certain classes, this is option allows subscribers more control over their NPS portfolio.
Auto-Choice
The Auto-Choice option, on the other hand, requires less involvement from the subscriber. You simply choose a plan depending on your risk appetite: Aggressive, Moderate or Conservative.
For each of these plans, there is a predefined allocation of asset classes, which vary depending on your age. As we saw in a previous edition, your risk tolerance changes as you age. And this is taken into account by the government when deciding the broad allocation of assets.
For younger individuals, the asset allocations are slightly riskier, with potentially better returns, and as you age, the distribution gradually shifts towards less volatile assets. You can find the exact distributions here.
How allocations are determined
As usual, a deeper understanding of investment instruments is key to identifying the best choices for you. So how are the allocations determined?
The government takes many factors into consideration when deciding the allocations, including market conditions, diversification, inflationary pressures, and risk tolerance.
The broad allocation may be adjusted under specific circumstances. Some situations where the allocation might be changed include changes in regulations, economic downturns, or emerging investment opportunities.
It's important to note that changes to the allocation strategy are typically made after careful consideration and analysis. The government, in consultation with the PFRDA and other stakeholders, aims to strike a balance between providing attractive returns and managing risks for NPS subscribers.
Consequently, the asset class allocations defined by the government can also give insights into the government’s economic outlook over the long term.
Tax Treatment
Of course, the main advantage of investing in NPS comes from the tax benefits.
There are two tiers of accounts in NPS. A Tier-I account is the permanent retirement account into which the regular contributions are made by the subscriber. A Tier-II account, on the other hand, is a voluntary / optional withdrawable account which is allowed only you have an active Tier-I account.
Tax benefits are only applicable for contributions to Tier-I accounts.
Contributions to the Tier-I account are eligible for tax deductions under Section 80CCD (1) of the Income Tax Act along with an exclusive deduction of up to Rs. 50,000 available under Section 80CCD (1B).
NPS is the only product available at present which allows you to invest in one instrument, and save under three sections of the Income Tax Act
As we have seen, while the finer details of NPS are rather complicated, things are greatly simplified from the perspective of an investor. But it is only by diving into the details that we can make more informed decisions.
We hope this edition helped you gain a better understanding of the National Pension Scheme as an investment avenue.
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Hey,
It is good to know more about these topics but it is a less creative, for reference you can refer sharan hegde newsletter about NPS. It is a little more concise & interactive.