NPS Vs. ELSS: Which is better?

Should you invest in NPS or ELSS?

A question that is asked by many who are looking to save taxes and invest for returns as well. The NPS vs ELSS and which is better depends on what is the investor’s exact requirement. But let’s try to compare these two tax-saving products on various parameters.

An Equity Linked Saving Scheme (or ELSS) is a equity mutual fund that provides tax deduction under Section 80C of the Income Tax Act. So as per the rules, an investor can claim a tax deduction of up to Rs 1.5 lakh under the section. But that said, the investor can invest even more than Rs 1.5 lac in ELSS, but there won’t be any additional tax benefits on the same. Also, these tax-saving ELSS schemes have a lock-in period of 3 years.

The National Pension System (or NPS), on the other hand, is a pension scheme that allows people to invest in it to save for retirement (and pension). In addition, as per the rules NPS subscribers can claim tax deduction under Section 80CCD(1) of up to Rs 1.5 lac. In addition, there is an extra tax benefit of Rs 50,000 under Section 80CCD(1B) for NPS exclusively. But, withdrawals from NPS are only allowed at the time of retirement at 60. That too a major part of it is to be used for the purchase of annuity compulsorily.

So obviously, NPS provides up to Rs 2 lac tax deductions while ELSS provides Rs 1.5 lac deduction. But that is not the only point when considering the differences between the two. You need to look at various other aspects to make the right decision between NPS and ELSS.

So let’s check these factors:

ELSS vs NPS – Expected Returns (%)

ELSS funds are pure equity funds and remain invested almost up to 95-100% in equities in the long run.

On the other hand, the NPS investors cannot have more than 75% equity in their NPS portfolio allocation (rest is in debt instruments). Also, such levels of equity allocation is only available to people under the age of 35 and who choose NPS Active Choice (Aggressive Life Cycle Fund: LC75). As the years pass, this limit gradually tapers off by a few percentage points every year. So technically speaking, NPS can never match the equity allocation of ELSS funds.

And since equity is known to deliver higher returns in the long run, it can be said that being pure equity product, it’s possible for ELSS to give better long term returns than NPS (as NPS has lower equity allocation). But that said, it also means that when stock markets are not doing well, then ELSS will underperform NPS due to its higher allocation to equity.

So there are pros and cons of high and low equity allocation in ELSS and NPS respectively

ELSS vs NPS – Taxation on Maturity

This is not about tax benefits as discussed in the first few paragraphs. This is rather about taxation of maturity amounts of NPS and after the lock-in period of ELSS is over.

ELSS is an equity fund. So the taxation will be in lines with what the tax rules are for equity funds. But since ELSS has a lock-in of 3 years and the definition of Long Term in Equity (for applicability of short term or long term capital gains tax) is 1 year, it is safe to say that Short Term Capital Gains (for less than 1 year) aren’t applicable in ELSS funds as they have a lock-in of 3 years.

So ELSS funds returns are treated as Long Term Capital Gains and taxed accordingly.

And as per the latest mutual fund taxation rules, the Long-term capital gains from ELSS (equity) funds are taxed at 10% if the gains are over Rs 1 lac in a financial year. Read more about LTCG Tax for Equity Investors.

On the other hand, NPS maturity amount is practically tax-free. Here are a few things to note as per the latest NPS Exit & Withdrawal Rules:

  • At least 40% of the accumulated NPS corpus is to be utilized for the purchase of an annuity at retirement. And the remaining amount can be withdrawn as a lump sum. The amount used to purchase an annuity is fully exempt from taxes.
  • The remaining 60% of NPS corpus is also exempt from taxes.
  • However, the annuity income (or pension) coming from the annuity plan will be taxed as per tax slab in the year of receipt.

So even though NPS at maturity is tax-free, it only defers the tax by making the annuity (pension) income taxable in retirement years. Read to know more about the latest NPS Tax Rules.

And just to complete the tax discussion from tax benefits angle, here are the same.

NPS vs ELSS: Tax benefits while investing

Both the schemes of NPS and ELSS are eligible for claiming tax deductions.

Up to Rs 1.5 lakh put in ELSS gets deduction under Section 80C.

NPS is also eligible for deduction under Section 80CCD(1) with an overall ceiling of Rs 1.5 lakh under Section 80C. But NPS subscribers also get an additional deduction of up to Rs 50,000 under Section 80CCD (1B). And if you are salaried and your employer also puts money in NPS, then you can claim more tax deductions up to 10% of their basic salary in the NPS under Section 80CCD(2). There is no cap on this deduction.

By the way, when referring to NPS, we are referring to NPS Tier 1 Account and not the Tier 2 account. Both types of NPS accounts serve different purposes and have different tax implications and lock-ins. You can read here more about the difference in NPS Tier 1 Vs NPS Tier 2 Accounts.

NPS vs ELSS: Flexibility on Investment Options

ELSS being pure equity scheme only invests the money in equity.

NPS being a hybrid product invests in both equity and debt (i.e., government securities, corporate bonds and alternative investments). So as an investor, it gives you more options. You also get to choose between how the NPS asset allocation is managed depending on whether you chose NPS Active Choice Vs. NPS Auto Choice.

  • In the NPS Active choice, you can specify the % of equity and % of debt you wish to have in your NPS corpus.
  • In NPS Auto choice, depending on the chosen option (amongst Conservative LC25, Moderate LC50 or Aggressive LC75), it deploys your NPS savings in pre-decided asset allocation. Different life cycle funds (LC25, LC50 and LC75) cater to investors with different risk appetites. Check this image for more details on LC25, LC50 and LC75 NPS Equity Schemes

Few things to note here are:

  • ELSS funds have a lock-in of 3 years. So you can’t shift or change or exit before that. But NPS allows investors to change the asset allocation once a year and also allows to change the pension fund managers.
  • And if you think about it, there is another interesting aspect. In ELSS, you can spread your investments across multiple ELSS funds and not just one. But in NPS, you cant do it as you have to pick just one pension fund manager for handling the entire NPS investment corpus (use this NPS Maturity Calculator to easily find out how much corpus you will accumulate using NPS on retirement).

ELSS vs NPS – Liquidity

Now, this is important.

ELSS has a lock-in of just 3 years. NPS, on the other hand, is practically illiquid till retirement at 60!

Nothing wrong with that as NPS is a retirement savings product and not a normal savings product. So it does exactly what it is designed to do.

In ELSS, once the lock-in period is over, you can withdraw the money, shift it to another ELSS fund or if you don’t want to invest further, then you can stop investing altogether.

In NPS, and in normal cases, you can withdraw only at the time of retirement or when you turn 60. Though partial withdrawals are allowed but only in specific cases like child’s higher studies and marriage or treatment of critical illness, etc. That too you can withdraw from NPS (before retirement) only 3 times during the entire tenure of the subscription.

So NPS is definitely not that liquid. And it is for this reason that before you decide to pick NPS, you should be very clear that money being invested in NPS is only for retirement planning because it is not possible to withdraw before that. And let’s not forget that even after retirement, you can’t get your hands on 100% of the NPS savings. Only 60% of the NPS corpus can be withdrawn as lump sum and the balance 40% of NPS corpus is to be compulsorily put in an annuity to get a monthly pension in retirement

Some of you may feel that NPS is too illiquid to consider it. I feel that it can actually be a blessing-in-disguise for many savers who aren’t very financially disciplined. If someone is prone to dipping into his savings unnecessarily, then NPS is a better option because of the restrictions it places on normal withdrawals. Atleast this way, the retirement savings will be protected against unnecessary dipping into.

Same is the case with PPF. People get little uncomfortable with a long lock-in period of 15 years in PPF, but that too can work very well for retirement savings for many people. Since both PPF and NPS have long-term lock-in periods, you may like to read this detailed comparison of PPF vs NPS.

Also, PPF and ELSS funds themselves are often compared when it comes to saving taxes and investing for wealth creation. So, if it interests you, then consider reading another detailed comparison of ELSS vs. PPF.

So what should you do and how to choose between NPS and ELSS?

This is not an easy question to answer because I don’t know what your unique situation is. One should never pick an investment product just by comparing them. You should also check what is the product-suitability in your particular case.

Its definitely possible that for someone, NPS may be a better option while for someone else, ELSS funds may be a good choice. And it is also possible that for some people, both NPS and ELSS can be there in the overall investment portfolio.

Also, these questions like NPS vs ELSS and investment choices, in general, should never be guided by tax savings considerations alone.

Do not invest in NPS solely from the point of view of saving taxes.

Also, do not invest in ELSS solely from the point of view of saving taxes.

If you are picking savings product for retirement planning, then you need to think hard as to how NPS or ELSS fit into the overall financial plan, recommended asset allocation and your risk profile as an investor.

You should try and find out how much you need for your retirement savings. And then find out which are the products suitable for retirement savings amongst EPF, PPF, NPS, ELSS funds, Equity Funds & Debt Funds.

It is possible that both NPS and ELSS fund can find a place in your portfolio. Or if you are already investing in EPF and Equity Fund SIP, then you can take the suitable Life Cycle Fund Choice of NPS. Or if you do not have the time and financial discipline to invest on your own, you can pick NPS Auto Choice and take help of SEBI Registered Investment Advisor to help plan your finances.

I know that if you are looking for a straight answer to NPS vs ELSS: Which One Is Better For Tax Saving?; then you still may not have got it. But that is fine. There is no right answer here. Different people have different needs and we cannot suggest financial products just on the basis of tax saving considerations.

Investing in mutual funds gives much more freedom to investors than with products with lock-in. And there are Mutual Fund SIP Success Stories to prove the importance of investing in mutual funds regularly. But instead of just trying to pick between ELSS Vs NPS on the basis of the difference between ELSS and NPS or trying to find ELSS vs NPS: Which is better to save tax and grow your wealth, sit down for a while and do yourself a small favor –

Get yourself a proper financial plan made.:

Stable Investor Financial Planning Service

 

And then be properly advised to choose the right financial products for your financial goals. Just investing randomly some amount here and there won’t take you anywhere in life.

No doubt both NPS vs ELSS and ELSS vs NPS in India can help you save tax and grow wealth. But you need to use these products in a proper way to get the full benefit in your financial life.

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