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National Pension System (NPS) is Not Illiquid

Author: AN Shanbhag Sandeep Shanbhag/Friday, October 13, 2017/Categories: Save, Invest, Profit, Grow, Expert View

National Pension System (NPS) is Not Illiquid

While it is believed that the NPS is per se a good product, the major greivance that most investors have is that it is illiquid – that one can access one’s contributions made to NPS only after attaining the age of 60 years. While this statement is true, it isnt true in its entirety. NPS has a number of liquidity infusing measures built into it and this time we shall be examining the same in detail. But first, a little background of the same.

NPS, is a defined contribution pension scheme. The first version was made applicable only to Central Government Employees (but not Armed Forces) joining service on or after 1.1.04. The previous pension scheme was a defined benefit scheme and was very beneficial to the employees. It benefited even those whose contribution was little, specially the ones who opted for VRS.

Now new employees have no choice. They have to contribute annually 10% of their salary to NPS. A matching contribution is made by the employer. FA07 (Finance Act 2007) extended the scheme w.e.f. 1.4.04 to employees of any other employers. Moreover, w.e.f. 1.4.09, the NPS has been made available to any citizen of India, including an NRI (but not a PIO) having bank account in India between the age of 18 and 60. Insolvent individuals who are not discharged by a court of law and persons with unsound mind are not eligible to join NPS.

This scheme was a darling of the government which desired to introduce the EET (Exempt contributions, Exempt growth, Tax withdrawals). The investors at large realised that this was only deferment of taxes and their take-home was the same whether the tax was applied upfront or at end.

Upfront Tax = Trail Tax.

Suppose you have `  1,00,000 investible and the current interest rate is 10% , the current tax rate is 30% (ignore the cess) and your investment horizon is 20 years. If you choose an EET scheme, your contribution will grow to  100000 (1.10)20. The tax thereon at withdrawal will be = {100000 (1.1)20} x 30% = 2,01,825. If you choose upfront tax, the take home will be = {100000 x  30%} x (1.1)20 = 2,01,825.

It was argued that on retirement, since the salary would no more be available, the tax rate will be lower and therefore EET is attractive.

In practice, thanks to the increment in the salary and the income from investments of the employee, this claim was not sustainable in most of the cases.

Evidently therefore the response was luke-warm.

Finally, the authorities have given an excellent boost to this scheme through repeated amendments, mostly incorporated through FA 17. Now, this is the way NPS looks:

Withdrawal after death of account-holder is exempt from tax

The entire accumulated pension would paid to the legatee/nominee of the account holder is tax-free. However, in the case of government employees, purchase of annuity plan is mandatory and the amount of monthly pension is taxable in the hands of the legatee/nominee.

Withdrawal at the time of retirement.

Maximum amount that one can withdraw at the retirement or achieving the age of superannuation as per the rules of the company is 60% out of which 40% is tax-free and 20% is taxable. The remaining balance 40% needs to be utilised for the purchase of annuity providing monthly pension.

Partial Withdrawals

A subscriber can withdraw up to 25% of the contributions made by him (and not by his employer or the gains thereon) after he has been in the NPS for at least 10 years for any of the following purposes :

a)            Higher education or marriage of his children including a legally adopted child.

b)            Purchase or construction of a residential house or flat in his name or in a joint name with spouse, unless he already owns one, other than ancestral property.

(c)           Treatment of the some specified life-threatening illnesses of self, the spouse, children, or dependent parents which shall comprise of hospitalisation and treatment.

The subscriber shall be allowed to withdraw a maximum of three times only after a period of five years have elapsed from the last date of each of such withdrawal unless it is for treatment for specified illnesses or the death of the subscriber. Sec. 10 has been amended to provide for an additional exemption on partial withdrawal not exceeding 25% of the contribution made by an employee.

For instance suppose your corpus at the end of its tenure is ` 2 lakh, consisting of your contribution of 1 lakh and a matching contribution of your employer. You can withdraw ` 25,000 which is 25% of your own contribution during its tenure and ` 70,000 which is 40% of the balance ` 1,75,000 (inclusive of the contributions of the employer) at the end of its term. The total works out at ` 95,000. On the other hand, if you do not withdraw any amount during its tenure, you will be allowed to withdraw only ` 80,000 (40% of the balance). All this is tax-free. With the rest of the amount you can buy an annuity which is taxable in your hands.

Withdrawal from NPS before retirement (irrespective of the cause)

If you want to withdraw from NPS before the age of 60 or before retirement (other than the purpose specified for partial withdrawal), the amount withdrawn will not be taxable but the amount that can be withdrawn is limited to 20% of the accumulated wealth in NPS and balance 80% of the accumulated pension wealth has to be utilized for purchase of annuity providing for monthly pension of the subscriber. However the annuity income shall be taxable in the year of receipt as per the income tax slab rate applicable to the subscriber.

100% withdrawal at the time of retirement/attaining the age of 60: In case the total corpus in the account is less than Rs. 2 Lakhs as on the Date of Retirement (Government sector)/attaining the age of 60 (Non-Government sector), the subscriber (other than Swavalamban subscribers) can avail the option of complete Withdrawal.

At End

It does appear that NPS has indeed become an attractive tax-saving avenue with its i) extra deductible amount of ` 50,000 u/s 80CCD(2). ii) possibility of earning higher returns, thanks to its lowest cost of maintenance and permitting the subscriber to choose a certain exposure to equities as per his risk appetite and most importantly iii) the freedom from tax on a large amount of withdrawals.

The authors, A.N. and Sandeep Shanbhag, are leading financial advisors. They can be contacted at wonderlandconsultants@yahoo.com

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