New Pension Scheme (NPS): Tier 1 vs. Tier 2
Here are few differences about New Pension Scheme (NPS) Tier 1 vs. Tier 2:
In a country, whose citizens still lag behind in retirement readiness, and frown upon the mandatory contribution to the Employee Provident Fund (EPF), the introduction of a pension plan, where the contribution was voluntary, raised many eyebrows. Experts were sceptical about the success, of the National Pension Scheme (NPS), which opened its doors, for the general public and private sector employees.
Ever since NPS was thrown open to the general public in 2008, the response has been mixed. A defined-contribution scheme, with expense ratio as less as 0.25%, it was believed to be a game-changer in retirement planning.
NPS has managed to generate decent returns in the last few years and outperformed the benchmark indices. However, unlike a mutual fund, NPS is primarily a retirement product, bound by many rules and regulations set by the PFRDA (Pension Fund Regulatory and Development Authority). It is strictly bound by withdrawal and exit regulations, framed by PFRDA, which are distinct for Tier 1 and Tier 2 options.
Let us understand more about the Tier 1 and Tier 2 options of NPS.
Tier 1 Option of NPS
Tier 1 is a very basic form of retirement account, in which the subscriber is issued a PRAN (Permanent Retirement Account Number). It falls under the E-E-T (Exempt-Exempt-Tax) regime, in which the contributions and gains made are exempt from tax, but the entire corpus on withdrawal is liable to tax, rather than just the gains made.
It has two distinct phases – the accumulation phase, which is the period of regular contribution, and the distribution phase, which is the period of receiving a pension from the accumulated amount.
Regular contributions to NPS are allowed a tax deduction under Section 80C up to a maximum of Rs.1.5 lakh. Additionally, a deduction of Rs.50,000 is also allowed for a contribution to NPS under Section 80CCD (1B), over and above the limit of Section 80C.
It has a very rigid withdrawal and exit policy, with only 25% of the accumulated corpus allowed for withdrawal after 3 years of opening the NPS account. Withdrawal is allowed for specific purposes like children’s education, marriage, construction or purchase of a first house, or treatment of critical illness of self, or immediate family. The limits on withdrawals are such that, they ensure the accumulated account is not wiped out completely.
The entry age of NPS is 65 years.
In Budget 2019, NPS withdrawal on maturity (i.e. when you complete 60 years of age) was made tax-free, up to 40% of the accumulated value. 40% has to be compulsorily used to buy an annuity plan. The annuity received is taxable in the hands of the annuitant, according to the tax slab rate.
Tier 2 Option of NPS
Tier 2 of the NPS, is a voluntary account with flexible withdrawal and exit regulations. A Tier 2 account, can be opened only if you have an existing Tier 1 account and a PRAN number.
It works very much like a savings account, in which the subscribers are allowed to make multiple contributions and withdrawals, without restrictions. You can also choose to not make any contributions in a year, and also maintain a zero-balance account.
If NPS is a retirement product, then where does Tier 2 fit in?
While Tier 1 of the NPS is a rigid retirement plan, Tier 2 gives you more flexibility for withdrawals, if needed. The idea is to promote a government-backed product, which offers equity exposure, helps you to plan for retirement (Tier 1), and also provides an option to invest for other life goals (Tier 2).
Many experts, compare the flexibility of Tier 2 with that of Mutual Funds (MFs). However, the expense ratio is much lesser than that of MFs and the wide variety of schemes available in MFs are absent in Tier 2 NPS.
The contributions to Tier 2 are not eligible for tax deduction. Is still subject to the EET tax regime, i.e. the entire withdrawal is subject to tax, and not just the gains made. Also, the major drawback is that the indexation benefit applicable for debt MFs, are not applicable for Tier 2 NPS.
What is similar, and what is different, between Tier 1 and Tier 2?
Similarities: Both Tier 1 and Tier 2 of the NPS, offer three different asset classes for investment – E (Equity), C (Corporate Debt) and G (Government Securities). They also provide auto-choice and active choice for asset allocation.
In Auto-choice, the asset allocation will be done in a life-cycle fund. In Active choice, you can decide the percentage of the funds you want to contribute to each asset class.
Differences: The Tier 1 and Tier 2 are fundamentally different in withdrawal and exit rules.
Tier 1 is a comprehensive retirement product, with a distinct accumulation (wealth building) and distribution phase (annuity phase). It is subject to restrictions, for withdrawals on maturity also. The contributions are eligible for tax deductions, and the annuity received in taxable according to your IT slab rate.
Tier 2 can be viewed as an investment vehicle, comparable to MFs, but with limited choices. It has very flexible withdrawal options and can be used for fund accumulation for any life goal. The contributions don’t carry any tax benefits, and withdrawals are taxable at your IT slab rate.
Let us look at this table to understand Tier 1 and Tier 2 better.
Should you invest in Tier 1 or Tier 2?
NPS gets a thumbs-down, regarding taxation. Though many people contend, that the lower fund management charges, make up for the cost of tax, in the long run, it’s hard to foretell the returns generated. The choice of fund managers and the choice of funds are also limited in NPS, as currently only 7 pension management companies are permitted to run NPS.
Tier 1 is a rigid retirement product, where buying an annuity is compulsory at maturity, with at least 40% of the accumulated corpus. Unfortunately, annuities generate poor returns, between 4-6% annually.
Tier 2 is a more flexible investment option, with multiple withdrawal options. This option is given to utilize NPS for other life goals. However, this is not suitable for long-term investment, as the exposure to equity is limited to 50%, and hence, one cannot bank on equity to create wealth in the long run. Though the C and G options have generated fairly good returns, comparable to other debt mutual funds, they make a poor choice for short-term investments also, because of taxation. The entire amount withdrawn is subject to tax at the applicable IT slab rates, and not just the gains made. Also, NPS is not eligible to claim indexation benefit, which helps in reducing the tax liability.
As you have grasped, neither the NPS Tier 1 nor the Tier 2 are suitable investments, regarding investment options or regarding taxability. Unless you are a government servant and NPS investment is compulsory, it makes sense to consider other options like PPF, Equity and Debt MFs, etc., to get a better deal on taxation and to generate better returns.