Difference between NPS Tier 1 and NPS Tier 2 Accounts

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NPS is a retirement savings product which is slowly gaining popularity in India. And when you want to invest in it, then NPS comes with 2 types of accounts – Tier I and Tier II.

The NPS Tier I account is the actual retirement savings account which gets a host of tax benefits and is actually used for accumulation of NPS retirement corpus.

On the other hand, NPS Tier II account is a voluntary account which allows NPS subscribers to park/invest the money as per their wish and take it out anytime.

Let us see what are Tier 1 and Tier 2 NPS accounts and how different are they from each other.

Difference between NPS Tier 1 and NPS Tier 2 Accounts

Let’s have a look at the differences under various heads.

NPS Tier 1 vs NPS Tier 2 Account: Account Opening

If you want to invest in NPS, then it is compulsory to open a Tier 1 account. That is the main retirement savings account. As for the Tier 2 account, it’s voluntary to open. So if you don’t want it, you can skip opening it. But if you do want to open it, then you cannot open NPS Tier 2 account in isolation. It has to be opened with the NPS Tier 1 account. So many people have the question – Can I open a Tier II NPS account without opening Tier I account? The answer is NO.

But both Tier 1 and Tier 2 NPS accounts are linked to the same PRAN (Permanent Retirement Account Number). There are no different account numbers for NPS Tier I and Tier II accounts.

NPS Tier 1 vs NPS Tier 2 Account: Tax Benefits on Contributions

I have already written about NPS Tax benefits (latest rules). But here are important points.

All the below-mentioned tax benefits are available on NPS Tier 1 accounts only.

  • Up to Rs 1.5 lac investment in NPS is eligible for deduction under Section 80CCD(1) in a financial year. This comes under the overall Rs 1.5 lac limit of Section 80C.
  • If you are an employee contributing to NPS, then the above deduction is capped at 10% of salary (Basic + DA). If you are self-employed, then it is further capped at 20% of the gross annual income.
  • In addition to the above benefit of Rs 1.5 lac, an additional deduction of Rs 50,000 for NPS in a financial year is available under Section 80CCD (1B). This deduction is an exclusive tax benefit for all NPS subscribers under Section 80CCD (1B) and it is over and above the Section 80C limit of Rs 1.5 lac.
  • If your employer also contributes to your NPS (in addition to your own contributions), then the employer’s contribution of up to 10% of Basic + DA is also eligible for deduction under Section 80CCD (2).
  • There is no upper cap (in terms of amount) on this tax deduction but it is limited by the 10% rule on Basic + DA. And this deduction is in addition to the limits of Rs 1.5 lacs (Section 80C) and Rs 50,000 (Section 80CCD(1B)). For obvious reasons, self-employed NPS subscribers cannot avail this deduction.

As mentioned earlier, these tax benefits are applicable for investments in Tier I NPS account only. So your investments in NPS Tier 1 account qualify for tax benefits under Section 80 CCD (1) Section 80CCD (1B) and Section 80CCD (2) as per the Income Tax Act.

But what about tax benefits on Tier 2 NPS Account?

  • There are no tax benefits on contributions made towards Tier II NPS Account.
  • But for Government employees, who make contributions in Tier-II account of NPS, the benefit of Section 80 C for deduction up to Rs. 1.50 lakh for the purpose of income tax is available, but with a lock-in period of 3 years. For non-government employees or self-employed individuals, there is no such tax benefit on NPS Tier 2 Account.

So to summarize, all the tax benefits for contributions in NPS are limited to your investment in Tier 1 NPS account only under Section 80CCD(1), Section 80CCD(1B) and Section 80 CCD(2). No tax benefit for contributions made to NPS Tier 2 account. Only government employees are eligible to also claim NPS Tier 2 contributions as tax deduction under Section 80C provided the investment remains locked-in for 3 years.

NPS Tier 1 vs NPS Tier 2 Account: Taxation on Maturity (NPS Exit)

As per the latest NPS Tier 1 Exit Rules, at the time of maturity, a minimum of 40% of the accumulated corpus is to be used for annuity purchase. And the remaining 60% of NPS corpus is available for lump-sum withdrawal.

  • As for the taxation part, both the 40% used for annuity purchase and 60% NPS withdrawal, are exempt from tax. That is, NPS corpus is tax-free at maturity.
  • But the annuity income (pension) received from the purchase of annuity plan using a minimum 40% NPS Tier 1 Savings, will be taxable in the year of receipt as per the tax slab of the pensioner.

Now NPS Tier 2 Account is a voluntary account and you are allowed to add and withdraw funds as and when you want. So what are the tax implications of Exit from NPS Tier 2 account?

It’s a grey area for now. The clarity on this part is missing as of now. It is possible that the gains from NPS Tier 2 account may get added in your income (in the year which you exit/withdraw) and taxed as per income tax slabs then. Or it is also possible that gains may be treated as capital gains and taxed accordingly. So exit/withdrawal from Equity fund (E) of NPS Tier 2 account may get tax treatment similar to equity fund – 15% tax on short term capital gains in less than 1 year and 10% tax on long term capital gains after 1 year. Whereas, exit/withdrawal from Government Fund (G) or Corporate Fund (C) may get tax treatment similar to that of debt mutual fund – For short term capital gains within 3 years, taxed as per tax slab and for long term capital gains, taxed at 20% after indexation. But as I said, the clarity on this is still missing for now.

NPS Tier 1 vs NPS Tier 2 Account: Exit / Withdrawal Rules

I have already covered the latest NPS Exit & Withdrawal Rules (Updated). But to give a comparison between NPS Tier 1 Account Exit & Withdrawal Rules VS NPS Tier 2 Account Exit & Withdrawal Rules, here is a brief summary:

All the below-mentioned exit/withdrawal rules are applicable to NPS Tier 1 accounts only:

  • When NPS subscriber reaches the age of 60 (or Superannuation), he will have to mandatorily use at least 40% of the accumulated NPS Tier 1 pension account corpus to purchase an annuity (which will give monthly pension).
  • The remaining corpus (60% or lower) can be withdrawn tax-free as a lump sum.
  • If the total accumulated NPS Tier 1 corpus is less than Rs 2 lac, the subscriber can make 100% lumpsum withdrawal.
  • If NPS subscriber decides to exit NPS before the age of 60 (like in case of voluntary retirement or early retirement), then he will have to use minimum 80% of the accumulated NPS Tier 1 account corpus to purchase the annuity. Only the 20% or less remaining corpus can be withdrawn tax-free as a lump sum.
  • Partial withdrawals can only be made from NPS Tier 1 account if the subscriber has an active NPS account for atleast 3 years.
  • Also, there is a limit on the amount of money that can be partially withdrawn from Tier-I account of NPS. The limit of withdrawal is up to 25% of only the NPS subscriber’s own contribution (excluding employer’s contribution). Therefore, if both you and your employer are jointly contributing to your NPS account, then the maximum amount that can be withdrawn from your account will be calculated on the basis of the contributions made by you only and exclude your employer’s contributions.
  • And the withdrawal from NPS Tier 1 account can only be made for the clearly-defined expenses like Children’s Higher Education, Children’s Marriage, Construction / Purchase of First House, Treatment of 13 critical illnesses for self, spouse, children and dependent parents and to start a new business venture. And no partial withdrawal will be allowed from the NPS account in any other situations.
  • Also, there are limits to how many times you can withdraw from the NPS Tier 1 account. The partial withdrawal, in accordance with above conditions, can happen a maximum of only 3 times during the entire tenure of NPS subscription. No further partial withdrawals will be allowed, once the individual has made three withdrawals. And these withdrawals are exempted from taxes.

What about NPS Tier 2 account Withdrawal and Exit Rules?

Now NPS Tier 2 Account is a voluntary account and you are allowed to add and withdraw funds as and when you want. So there is full liquidity in NPS Tier 2 Account. That is, there is no restriction on withdrawals from NPS Tier-II account. You can withdraw the amount whenever you want. But if you are a government employee and claiming NPS Tier 2 contributions as tax deductions under Section 80C, then there is a lock-in of 3 years for your contributions to NPS Tier II account.

As for the type of withdrawal from NPS Tier 2 account, there are options to go for complete withdrawal or you can instead go for scheme-wise withdrawal from any of the funds, namely NPS Fund E, Fund C or Fund G (read more about NPS funds types)

The purchase of an annuity is mandatory for NPS Tier 1 account holders at exit (minimum 40% or 80% depending on whether the exit is at 60 or earlier respectively). But there is no compulsory purchase of annuity necessary in case of exit from NPS Tier 2 account. As mentioned earlier, you can withdraw the entire amount as a lump sum in one go.

NPS Tier 1 vs NPS Tier 2 Account: Minimum Contribution (Initial)

 All NPS subscribers need to make an initial contribution at the time of registration, as follows:

  • Minimum of Rs 500 for Tier I NPS account
  • Minimum of Rs 1000 for Tier II NPS account

NPS Tier 1 vs NPS Tier 2 Account: Minimum Contribution (After Registration in Later Years)

After the opening of NPS Tier 1 and NPS Tier 2 accounts, subscribers need to make some contribution every year to keep the NPS account active. The minimum contributions and rules are as follows:

  • NPS Tier 1 – Minimum amount per contribution – Rs 500
  • NPS Tier 1 – Minimum contribution per Financial Year – Rs 1000
  • NPS Tier 1 – Minimum number of contribution per Financial Year – One
  • NPS Tier 2 – Minimum amount per contribution – Rs 250
  • NPS Tier 2 – Minimum contribution per Financial Year – Nil
  • NPS Tier 2 – Minimum number of contribution per Financial Year – Nil (Not applicable)

NPS Tier 1 vs NPS Tier 2 Account: Investment Option (NPS Fund Choices)

  • The fund options (E, G, C and A) and investment choices (Active or Auto) are the same for both NPS Tier I account and NPS Tier II account.
  • But you have the freedom to choose different fund managers and/or fund options for both Tier 1 and Tier 2 accounts if you want.
  • As of now, NPS offers two investment options (Auto or Active) and four Asset Classes (Equity, Government Bonds, Corporate debt and Alternative Funds). You can read more here at NPS Active Choice Vs Auto Choice Investment Options (Latest Rules).

NPS Tier 1 vs NPS Tier 2 Account: Transfer from Tier 1 to Tier 2 or transfer from Tier 2 to Tier 1

Since the NPS offers two types of accounts – NPS Tier 1 and Tier 2, its obvious that question about whether you can transfer from one NPS account to other is bound to arise.

The NPS Fund Transfer rule is pretty simple. You can transfer funds from NPS Tier 2 account to NPS Tier 1 account. But you cannot transfer funds from NPS Tier 1 account to NPS Tier 2 account.

And I think this rule is fine. Or if you were allowed to easily transfer money from Tier 1 to Tier 2 and take the easy exit (bypassing the stricter withdrawal rules of Tier 1), then NPS would not serve its purpose of a low-liquidity pure-retirement savings product. Isn’t it?

So that was about all the major differences between NPS Tier 1 account vs NPS Tier 2 accounts.

Many people invest in NPS just to get that extra Rs 50,000 tax benefit. But when it comes to retirement planning, you should focus more on product suitability for retirement savings and not just on tax benefits.

To get an idea about how you can use NPS to save for retirement, use this NPS Maturity Pension Calculator (Free Download) to see how much you will get from NPS Tier 1 account at retirement.

There are many other products which too are a good choice for retirement savings like EPF (and VPF), PPF (Public Provide Fund) and doing SIP in Good Equity Funds. The NPS Tier 1 account can also be a good retirement savings option for many people. But is it suitable for you will depend on your unique requirements. It is best to find yourself a good advisor to help you with:

Proper Retirement Planning Service (Fee-Only)

 

Irrespective of whether NPS Tier 1 account is suitable for retirement savings or not, the question which you may have now is whether you should invest in NPS Tier 2 account or not?

Personally, I feel NPS Tier 2 is not required for retirement savings but may still be considered when saving for other financial goals (use this free financial goal planner excel sheet). But that said, many financial goals can be handled simply and easily by investing in few good equity and debt funds. Again, the actual need will depend on a person’s unique requirements.

Over the years, NPS is gradually being updated and made tax-friendlier to make it a good retirement savings product. And there is no doubt that it is a decent product. But whether it actually is good for you is something that should be decided after you have had a look at your full finances and needs and requirements. A good financial plan can help you answer such questions. So now you know the difference between Tier 1 and Tier 2 Accounts of NPS in India.

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