What is National Pension System and how it works

Building a sizeable retirement corpus is an important aspect of financial planning. Simply because it will not only take care of your expenses in golden years, but also help you sail your life post retirement without any ups and downs.

national-pension


Building a sizeable retirement corpus is an important aspect of financial planning. Simply because it will not only take care of your expenses in golden years, but also help you sail your life post retirement without any ups and downs. 

Essentially there are two stages in a person's lifecycle, namely accumulation stage and retirement stage. During the accumulation stage, an individual builds a corpus by investing in a mix of assets commensurate with his appetite and capacity to undertake risk. The trade-off between risk and return plays a pivotal role in governing his decision. In the retirement stage, the individual looks for a steady stream of income which can take care of his life after retirement. The size of income post retirement, in turn, depends on the size of his corpus built during the accumulation stage. 

At this juncture, the question that arises in our mind is, how to build a corpus that can take care of our lives post retirement? With this aim in view, the government introduced the National Pension System, popularly known by its acronym NPS. It is a defined contribution pension system in which the contributions are invested in a mix of assets and the retirement corpus is dependent on the returns from those assets. The returns in NPS are market-linked. Dedicated pension fund managers are entrusted with the task of managing the investors' money. 

Under NPS, an investor can open two accounts, called Tier I and Tier II account. Tier I account is a non-withdrawable permanent retirement account whereas Tier II is a voluntary withdrawable account. Tier II account can be opened only when you have an active Tier I account. The minimum contribution in Tier I account is Rs 500 for all transactions and Rs 6000 for a year. For Tier II account, the minimum contribution for opening an account is Rs 1000 and Rs 250 is charged for subsequent transactions. 

An investor in NPS has two choices to invest in, namely Auto choice and Active choice. In the Auto choice, the allocation amongst assets is done as per a predetermined formula based on the age of the investor. The allocation is made in 3 asset classes, namely Equities (E), Corporate Bonds (C) and Government Securities (G). Under Active choice, the choice of allocation lies with the investor. There is however a cap of 50% for investment in equity. For government sector, the cap on equity is increased to 15%. 

On turning 60, an investor can exit from the NPS but 40% of the pension wealth has to be utilised for the purchase of an annuity. If an investor withdraws the corpus before reaching 60 years of age, he will have to invest 80% of the accumulated corpus for buying an annuity. These exit conditions only apply to the NPS Tier I account, which is a pre-requisite for having a Tier -II account in NPS. 

As per current tax laws, investment of up to 10% of basic pay plus dearness allowance or a maximum of Rs 1.5 lakh, whichever is lower, is deductible from gross taxable income. From FY2015-16, an investor is allowed an additional deduction of Rs 50,000 from gross taxable income for investing in NPS. This deduction is over and above the maximum tax deduction of Rs 1.5 lakh under Section 80C. Hence the total tax benefit for investing in NPS is Rs 2 lakh. Only an investor in Tier I account can claim the above tax benefits. 

NPS is currently subject to the Exempt Exempt Tax (EET) structure. This means that contributions to NPS and accumulation/growth of these are not taxed, but the lump sum withdrawn on exit from NPS is taxed. The amount that is used to buy the annuity is however not subject to tax. This means that if an investor uses 100% of the accumulated corpus for buying an annuity, then he won't be subject to taxation. Only the pension income that he gets will be taxed like any other pension. In Budget 2016, the finance minister has made withdrawals from NPS on maturity tax-free up to 40% of the total corpus accumulated. This is a welcome step as it has made NPS more attractive for investors. 

(Readers are advised to consult their tax advisor(s) for detailed advice)

Source: Economic Times

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