NPS is still Tax Inefficient and flawed product!

The National Pension Scheme (NPS) was launched in 2004, as a pure-defined contribution product based pension system, which seems still confused about its design, marketing and taxation even after eleven years since its launch. The scheme has failed to nudge people into long-term savings that might provide a comfortable retirement income due to its cumbersome structure, the corpus taxed at the time of maturity and hence, technically flaw in product itself. With a view to giving a major boost to the NPS, the finance ministry decided to credit Rs 1,000 into each account opened in 2010, for five years to make the product more attractive. Even though, the scheme has not gained so much ordinary people. To rejuvenate and make more attractive the scheme, the Union budget 2015-16 has not only proposed to increase the tax-deductible investment limit for NPS under section 80CCD from Rs 1 lakh to Rs 1.50 lakh but allowed as an additional deduction of Rs 50,000 under a new inserted section 80CCD(1B), over and above the limit under section 80C. Also, doors have been opened for the scheme to compete with the Employees’ Provident Fund (EPF) by allowing an employee the option to choose between the two retirement vehicles. After this announcement, many people may be thinking about using this scheme to make route to pension planning and seeking to have another reason to save additional tax. But, the unfortunate answer is that there is no clarity about its returns and the exact tax incidence at time of maturity. Will you invest into that product where no one knows with certainty, and no one in the government has bothered to clarify? So, before investing into the product, it is imperative to understand its core features, explore other options and its tax advantages. Read the fine print and make decision as own.

Synopsis of NPS

Like other long-term investment products, the scheme is allowed with a minimum annual contribution of Rs 6,000 and money get locked in till the age of 60. The contributions and investment returns would be deposited in the so called Tier-I account, which cannot be withdrawn. At 60, one will be required to invest 40% of the proceeds have to be compulsorily invested in buying an annuity that given periodical payouts. The remaining 60% can be withdrawn as lump sum. Being the vesting age is 60 years, prior withdrawals are discouraged, that one can withdraw only 20% of the corpus during an emergency. Like any ULIP, it offers also flexibility of choosing from various combinations of debt and equity plans subject to the maximum exposure to equity is limited to 50%. While it is true that NPS returns are market-linked and therefore bound to be volatile, it is good for those who can stomach some amount of risk. That’s all!

Double whammy of Taxation

Although you now get additional tax deduction for what you invest in NPS, the maturity proceeds are still taxable. This means you have to pay income tax on the 60% that you withdraw from NPS. The annuities that you get are again considered income and are taxable. Under the most other tax-saving and long-term investment products such as public provident fund (PPF), insurance or equity –linked saving scheme, you get a deduction of only up to Rs.1.5 lakh under section 80C. But the proceeds from it are tax-free which get more tax-efficient than NPS appears. Hence, for NPS, the entire corpus withdrawn is added to your income and taxed in line with your applicable slab rate. This could significantly eat into your returns during retirement, especially if in the highest tax bracket.

Pre-retirement Corpus

Let’s visualize and get in real study on some other options which would get more clarity and help to choose best product for accumulating corpus in your pre-retirement years and distributing corpus in post-retirement years.

Option 1 (NPS)

Suppose, you at the age of 35 years, intend to invest Rs 50,000 for the next 25 years, your NPS corpus at retirement get compounded average return of 10% would generate corpus of Rs 54.09 lakh before taxes. While exiting, 60% of this corpus can be withdrawn and the rest needs to be invested in an annuity. This 60% (i.e. Rs 32.45 lakh) will be full taxed as per your currently prescribe rate of slab. While assuming at the current highest tax rate, 30.9%, you will have to be left with Rs 22.42 lakh. The remaining 40% of the corpus is not taxed but has to be invested in an annuity. Since, returns from annuity are meager and are also taxed, you will earn only 4% return from the annuity and the total amount invested in the annuity would be Rs 21.64 lakh. On the reciprocal side, your annual investment of Rs 50,000 in NPS would help to save tax for the next 25 years. Every year, you would save around 30.9% on Rs 50,000 (i.e. Rs 15,450) by way of tax. Assuming, if you invest this saved money into fixed income products until you are 60, which normally get a post-tax return of 5.5% p.a., would fetch a corpus of only Rs 8.34 lakh. All in all, you could have accumulated a paltry sum of Rs 52.43 lakh by taking the advantage of the new Budget provision while investing in NPS.

Option 2 (Equity Mutual Fund)

Let’s consider, if you invest Rs 50,000 every year in a top-performing equity mutual fund scheme rather than NPS. The corpus would be worth Rs 1.04 crore while assuming a compounded average annual return of 14% and this entire amount would be totally tax-free. You would earn almost double the amount than investing in NPS, plus not by stuck with an annuity. Sound familiar!

Option 3 (PPF)

What if you invested RS 50,000 in PPF for the next 25 years, the corpus would grow to Rs 44 lakh with an annual interest of 8.70%. This too would be tax free.

Post-retirement Corpus

So, if you choose the first option as NPS, you are stuck with an annuity and you would have cash in hand of Rs 30.76 lakh (i.e. Rs 22.42 lakh + Rs 8.34 lakh) and an annuity of Rs 21.64 lakh. You can invest the Rs 30.76 lakh in the fixed products, through which you will earn post-tax interest 5.50% whereas the annuity will earn post-tax return 4%. After 20 years, including the interest payout, your corpus would be worth Rs. 1.04 crore.

In Option 2, you invest the entire corpus of Rs 1.04 crore in fixed-income products earning 5.50% annually. Here you avoid low-yielding annuity products. By doing so, after 20 years of retirement, your corpus, including the interest income, would be worth Rs 2.18 crore. This is nearly two times higher than if you had chosen Option 1 of the NPS.

In the last option, where you choose to invest in PPF, your corpus of Rs 44 lakh would be worth Rs 92.40 lakh in 20 years into retirement while assuming a return of 5.50% annually. Therefore, if we compare all the options, investing Rs 50,000 in top performing equity mutual fund schemes will be a better option than investing in NPS. So, for a 35-year-old with a tenor of 25 years, you will need to generate over 5% additional return annually in NPS to nullify the corpus difference with equity mutual funds. PPF loses out as the corpus is about 10% lower than that of NPS. But, remember, the returns from PPF are fixed, compared to a market-linked return of NPS.

Asset Allocation

There is a fourth option and may be the best option which offers a standard asset allocation, say 70:30 towards equity and debt. Here, you could invest 70% of the yearly Rs 50,000 investment in equity mutual funds and the balance 30% in PPF. On doing so, at the time of retirement, the corpus would be worth Rs 85.78 lakh and, by the time you are 80, the corpus including interest income earned would be worth Rs 1.80 core. This would be a much better alternative to investing NPS. It gives you the wealth creation of equity and the stability of fixed-income products, in addition to tax-free income on maturity.

Conclusion

After an evaluation of the scheme, drawbacks and other options, therefore, NPS has not found much favour with investors even giving extra Rs 50,000 deduction from taxable income. One should not go for complex products to execute the desired asset allocation. Many good long-term simple equity and debt products that can be used for retirement planning such as top-performing equity mutual funds, PPF etc. You can choose between these products or opt for a combination of these instruments, but you must be disciplined and continue investing over a long period. Likewise, you need to ensure that the features suit your risk profile, financial goals and investment horizon. Overall, NPS would remain an unattractive proposition even if you get an additional a tax break. Yet, another finance minister, it seems, could not understand what makes people choose long-term investment.

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