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When it comes to retirement planning in India, the NPS or National Pension System is slowly getting more and more attention by retirement savers in 2020-21.
But many people are still not very clear about exactly What is NPS and more importantly, How NPS works? And since NPS helps in accumulation of retirement corpus which is then used to generate pension using an NPS annuity plan, many people want to clearly understand What is Annuity in NPS?
With these thoughts in mind, I wanted to write a Super-detailed Guide on National Pension System (NPS). Many people still call NPS as the National Pension Scheme but it doesn’t really matter.
I will try to have the National Pension Scheme NPS explained with examples in this post.
So if you are looking to subscribe NPS in 2020 to save for retirement, then this NPS explained simply guide will help you understand various important aspects of National Pension System (NPS) and How NPS works (in full detail) and also What is annuity in NPS and what you should know about it before you become an NPS subscriber.
So let’s see how to go about Retirement planning with the National Pension Scheme.
What is NPS (National Pension System) in India?
Retirement is one goal on which you just have one shot. You cannot get it wrong else you will run out of money in old age. And you don’t want that. So gradually building a sufficiently large retirement corpus is an important aspect of financial planning. That is the whole agenda of How National Pension System works in India.
NPS is a Defined Contribution Pension Scheme backed by the Indian government to provide pension schemes to all the Indian citizens. It is managed and regulated by the PFRDA India (or Pension Funds Regulatory Development Authority).
It’s a portable retirement savings account and you can subscribe to NPS irrespective of whether you are a Government Employee, Private Corporate Employee, Self Employed or a working Professionals. NPS is indeed available for all those who wish to save for their retirement years.
And NPS has two phases:
- NPS Accumulation Phase
- Retirement or NPS Annuity (Pension) Phase
During the accumulation phase, you invest small amounts over a period of several years to build the NPS corpus in a mix of assets which are suitable for investors risk appetite and capacity and real risk tolerance.
While in the retirement of NPS pension phase, a part of the NPS corpus (accumulated during accumulation phase) is used to put in place a steady stream of income (or pension) for the life after retirement. So that is in plain language, what is annuity plan in NPS.
And it goes without saying that the pension income post-retirement will depend on the size of NPS corpus accumulated during the accumulation phase.
And why is NPS called as the Defined Contribution Pension Plan?
Its because the NPS subscriber contributes to his account but there are no defined benefits that would be available at the time of exit from the system (at retirement). So you can control the contribution to the NPS pension account but you do not control your final pension income.
The accumulated NPS corpus would depend on the contributions made and the returns generated from the investments made during the accumulation phase.
So the greater the value of the contributions made to NPS or/and greater the investments returns achieved and/or longer the term over which the NPS accumulates, the larger would be the NPS corpus and bigger would bet the eventual benefit NPS pension income in the later years.
Its that simple.
To summarize (and we will look at in more detail in the latter part of this guide), under the National Pension System (NPS), you contribute to the NPS account before retirement in working years. Your NPS investment earns market-linked returns. And when you retire, you can withdraw a portion of the accumulated NPS corpus as a lump sum while the remaining is to be utilized to purchase an annuity plan which provides pension during retirement years.
As I said earlier, everyone can join NPS:
- Employees in Central Government: Alongwith employees contributions, the employer (which is the central government) also makes a matching contribution to employee’s NPS account.
- Employees in State Government: Alongwith employees contributions, the employer (which is the state government) also makes a matching contribution to employee’s NPS account.
- Employees in the Private Corporate Sector
- All Citizens of India: Any person not in the above three categories can join NPS All-Citizen’s Model
So basically Who can join NPS? Any individual citizen of India (both resident and Non-resident) in the age group 18-65 years can join NPS. Can an NRI join NPS? Yes. NRI can open NPS accounts. But OCI (Overseas Citizens of India), PIO (Person of Indian Origin) cardholders and HUFs are not eligible for NPS account. Also, opening NPS accounts jointly is not allowed. NPS account can only be opened by individuals. There is also a slight difference in how NPS works for government employee and how NPS works for private employee.
And many people have a doubt “Can I still invest in NPS if I have invested in any Provident Fund?”
The answer is Yes. The investments in NPS can be made even if you are already saving money in EPF, VPF and PPF. Your NPS account is independent of contributions to any Provident Fund.
What is NPS Additional Tax Benefit Rs 50,000?
For the government employees who are mandatorily enrolled in NPS, there is no option. But for others, what is attracting them to NPS is the additional tax benefit of Rs 50,000 in a financial year that is available over and above Rs 1.5 lac limit of Section 80C. This extra tax benefit is exclusive for NPS subscribers (Tier 1) and comes under Section 80CCD (1B).
Though investment decisions should never be made on the basis of tax benefits alone (read why?), many feel that restricting NPS investments to just Rs 50,000 per year and investing remaining money earmarked for retirement savings in other retirement suitable options like EPF, PPF and Equity Funds can be a good strategy for most people.
But this is something which would depend on the individual’s requirements and to be fair, there cannot be a one-size-fits-all approach to NPS investing.
Let’s move on and see how NPS is structured.
Difference between NPS Tier 1 and NPS Tier 2 Accounts
When you want to invest in NPS, it comes with 2 accounts – Tier 1 and Tier 2.
The Tier I is the actual retirement savings account which gets a host of tax benefits and is used for accumulation of NPS retirement corpus. Tier II, on the other hand, is a voluntary account which allows NPS subscribers to park/invest the money as per their wish and take it out anytime.
So what are the differences between the two accounts?
- NPS Tier 1 vs NPS Tier 2: Account Opening: If you want to invest in NPS, then it is compulsory to open a Tier 1 account. Opening the Tier 2 account is voluntary. If you don’t want it, you can skip it. But if you do want to open it, then you cannot open NPS Tier 2 account without opening NPS Tier 1 account first. But both NPS Tier 1 and Tier 2 accounts are linked to the same PRAN (Permanent Retirement Account Number).
- NPS Tier 1 vs NPS Tier 2: Tax Benefits: All tax benefits are applicable to NPS Tier 1 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. No tax benefit for contributions made to NPS Tier 2 account (barring few for government employee’s Tier 2 contributions). We shall look at NPS taxation in more details in later sections.
- NPS Tier 1 vs NPS Tier 2: Exit Rules: Discussed later in more detail.
- NPS Tier 1 vs NPS Tier 2: Minimum Contribution (Initial): At the time of registration, a minimum of Rs 500 for Tier I NPS account is required. While a minimum of Rs 1000 for Tier II NPS account is required.
- NPS Tier 1 vs NPS Tier 2: Minimum Contribution (After Registration): After the opening of NPS Tier 1 and NPS Tier 2 accounts, subscribers need to make some contribution every year. These are NPS Tier 1 – Minimum amount per contribution – Rs 500 (and minimum contribution per financial year – Rs 1000 and a minimum number of contributions per financial year is 1). And for the other NPS Tier 2 – Minimum amount per contribution – Rs 250 (and minimum contribution per financial year is Nil and a minimum number of contributions per financial year is Nil).
- NPS Tier 1 vs NPS Tier 2: Investment Option (Fund Choices): Discussed later in more detail.
- Transfer from Tier 1 to Tier 2 or transfer from Tier 2 to Tier 1: 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.
So that was about all the major differences between NPS Tier 1 Vs NPS Tier 2 account.
Now let’s have a look at the various investment choices that are available in NPS
NPS Investment Difference between Active & Auto Choice
NPS allows you to invest in different asset classes in which the various NPS funds can invest. There are basically 4 asset classes:
- E: Investments in Equity instruments
- G: Investments in Government Debt securities
- C: Investments in Corporate Bonds, i.e. debt instruments other than government debt securities
- A: Investments in Alternative Investments (like REITs, Infrastructure Investment Trusts, AIFs Cat I and II, etc.)
While the asset classes remain the same for all subscribers, the allocations to each one can and will differ based on what the investor chooses. It goes without saying that the total allocation of E + G + C + A should be 100% and depending on NPS investment choice made, the Equity Exposure (E) is capped for a different choice of asset allocation as will be seen shortly.
Now comes the important part.
NPS allows you to manage your investments in 2 ways:
- Auto Choice
- Active Choice
I am sure you would be curious to know the difference between active choice and auto choice in NPS. So here are the details:
NPS Auto Choice
The NPS Auto Choice is an option provided for those NPS subscribers who do not have the required knowledge to manage their investments or do not want to manage it on their own. Under this choice, the investments are made in a life-cycle fund.
For the Auto Choice, there are 3 Life Cycle Funds (LC) to choose from:
- Aggressive Life Cycle Fund (LC75)
- Moderate Life Cycle Fund (LC50)
- Conservative Life Cycle Fund (LC25)
The idea of these Life Cycle options is to assist individuals who need help in deciding their investment’s asset allocation.
Let’s see one-by-one how these NPS Life Cycle Funds differ in their asset allocation.
Aggressive Life Cycle Fund (or NPS Auto Choice LC 75)
As the name suggests, this is suitable for investors who want higher exposure to equity in their investments.
Under this option, the equity (E) component is at 75% up to the age of 35 and then, it gradually tapers down to 15% by the time investor is turns 55. After 55, the allocation remains the same (at 15%) until he exits NPS. Here is how the equity component comes down from 75% initially to 15% eventually:
Conservative Life Cycle Fund (or NPS Auto Choice LC 25)
This life cycle fund is suitable for investors who are conservative and don’t want a very higher exposure to equity. They being risk-averse investors, are best suited for low equity component in their investments via NPS.
Under this option, the equity (E) component is at 25% up to the age of 35 and then, it gradually tapers down to 5% by the time investor is turns 55. After 55, the allocation remains the same (at 5%) until he exits NPS. Here is how the equity component comes down from 25% initially to 5% eventually:
Moderate Life Cycle Fund (or NPS Auto Choice LC 50)
This life cycle fund is suitable for more balanced investors who lie between the conservative and aggressive risk appetite.
Under this option, the equity (E) component is at 50% up to the age of 35 and then, it gradually tapers down to 10% by the time investor is turns 55. After 55, the allocation remains the same (at 10%) until he exits NPS. Here is how the equity component comes down from 50% initially to 10% eventually:
Under all the Auto Choice option (LC75, LC50 and LC25), the rebalancing (or reallocation) among the asset classes happens automatically once every year (on date of birth) as given in the Life Cycle Investment Matrix. The asset allocation is changed (if required) and the existing assets are redeemed and reinvested as per the new ratio of allocation. The NPS subscribers do not have to do any asset allocation on their own and hence the name Auto Choice NPS.
So this life-cycle based ‘NPS Auto Choice’ approach not only tries to optimize overall returns but also attempts to cushion the NPS corpus from market volatility as it approaches maturity.
By the way, for the Government NPS subscribers, the equity allocation is capped at 50%.
That is another aspect where you can say that how NPS works for government employee differs from how NPS works for private employee.
That was the Auto Choice.
Next is the Active Choice – where you get a say in what allocation your NPS portfolio should have.
NPS Active Choice
The name is self-explanatory. This choice is for those who want to decide the asset class allocation on their own. In the NPS Active Choice, the subscriber has the option to choose the ratio in which his / her funds to be invested among various asset classes. That is, you get a say in your asset allocation.
Are there any limits on the asset classes in Active Choice?
Yes, there are. But not as comprehensive ones as in the Auto Choice.
Under the Active Choice, the NPS investor can have a maximum of 75% in Asset Class E (Equity). This is up from the earlier limit of 50%. But when the subscriber reaches the age of 50, the equity portion will taper off by 2.5% each year till it reaches 50% percent by the age of 60 years. This is according to a fixed schedule as set by PFRDA for NPS Active Choice:
Those are the basic differences in Auto Choice and Active Choice of NPS.
And while active choice is meant for those who want a greater say in their asset allocation, the auto choice is meant for investors who prefer a more passive approach and/or need some advice on proper retirement savings asset allocation.
By the way, you may ask as to how many times can one change the NPS Choice from Auto to Active or from Active to Auto? The answer is that a subscriber can change of scheme preference once in a financial year for each of Tier I and Tier II account. And when you move to Active choice (from Auto choice), then you are also allowed to change your asset allocation once in a given financial year.
You can read more useful FAQs about NPS investment schemes here.
Apart from being able to decide your asset allocation (Actively via Active Choice or Passively via the Auto Choice), you can also choose your Pension Fund Manager (PFMs).
These PFMs are actual entities who invest the NPS funds as per the guidelines issued by PFRDA from time to time. As an NPS Subscriber, you have the option of selecting any a PFM. At present, there are following NPS Pension Fund Managers
- LIC Pension Fund
- SBI Pension Fund
- UTI Retirement Solutions
- HDFC Pension Management
- ICICI Prudential Pension Fund Management
- Kotak Mahindra Pension Fund
- Birla Sun Life Pension Management
To find out the Best NPS Pension Fund Manager and their returns across various assets, please refer to this updated NPS Pension Fund Manager Returns or you can have a look at the NAV of NPS Pension Funds.
And subscribers are also allowed to change the Pension Fund Managers once in a year free of cost.
Many NPS subscribers make the mistake of looking at just the Equity Returns of NPS Scheme E and trying to make an assessment of whether NPS is giving good returns or not. But only considering returns Equity Funds of NPS in isolation can be misleading. Let me explain why.
As you know, NPS offers two investment choices to its subscribers:
- Active Choice
- Auto Choice
As per the NPS investment rules, the maximum allocation that can go into equities in your NPS account is capped at 75% of the investment. The balance has to be compulsorily invested in debt (government bonds and corporate debt).
So for an NPS investor, looking only at NPS equity (Scheme E) returns in isolation is not the right way. In addition to equity returns (Scheme E), investors should also look at what returns have been delivered by the scheme G and scheme C. Isn’t it?
NPS scheme E invests predominantly in equity instruments up to a maximum of 75%. The balance has to be compulsorily divided between NPS Scheme G (which invests into government securities) and NPS Scheme C (which invests into fixed income instruments of corporates).
So even if someone has maximum equity exposure at 75% (in scheme E), its obvious that remaining 25% NPS portfolio is parked in Scheme G and/or Scheme C. So returns earned by the overall NPS portfolio will be proportionate.
Suppose you are an NPS subscriber aged 38 who invests in NPS Auto Choice (Aggressive Life Cycle Fund – LC75) for his retirement.
Now if you check the NPS Aggressive LC75 Fund, then you will see that for age 38, the equity component (E) is capped at 63%, G at 24% and C at 13%:
Now let’s also pick a Pension Fund Manager at random and see what returns their 3 schemes (E, G and C) have generated. And let’s focus on 3-year returns:
As you can see, in the 3-year period here, scheme E gave 14.57%, scheme G 6.07% and scheme C gave 7.65%. And since only 63% of your NPS was parked in scheme E, only that part of the corpus earned scheme E’s returns of 14.57%. The remaining scheme G (24%) earned 6.07% while money parked in scheme C (13%) got returns of 7.65%.
And this is the reason why you need to look at returns given by all the schemes where you NPS is investing and not just NPS’s equity scheme’s returns.
All said and done, remember that the NPS returns are not guaranteed. There is no concept of NPS interest rates as the returns are market-linked. They are dependent on the performance of the underlying assets – equity E, government securities G and corporate bonds C.
Like any other investment product, NPS also benefits from compounding. So more the invested money, the more the accumulated amount and the larger would be the eventual benefit of the accumulated pension wealth. To find out the Best NPS Funds Managers (2020) and to check returns generated by NPS schemes, please check out this link – NPS Scheme Fund Manager Returns.
Now you may be interested in knowing the following:
- How much money you can accumulate in NPS by retirement?
- How much NPS retirement corpus will you have?
- How much tax-free withdrawal is allowed from NPS at retirement?
- How much will be your retirement NPS pension?
For answering such questions, I have created a small free excel based NPS calculator. This NPS calculator acts as a tool that you can use to estimate the NPS retirement corpus and monthly pension when you retire at 60.
It is a simple, easy-to-use and can be used as an NPS Pension Calculator and NPS Annuity Calculator as well. It’s a basic version and hence, illustrates only the following:
- NPS Corpus accumulated by retirement (age 60)
- Tax-Free Lumpsum withdrawal available
- Pension amount or annuity payable on retirement (after the purchase of annuity using a minimum 40% of the NPS corpus accumulated)
Under the latest NPS rules, you are not allowed to withdraw the entire amount at maturity and need to purchase an annuity using at least 40% of accumulated NPS corpus at retirement. The remaining 60% of the corpus can be withdrawn tax-free. This annuity purchased is the source of pension income after retirement.
Hence, once you are able to estimate your final retirement NPS corpus, you can then easily estimate post-retirement monthly pension using prevalent annuity rates. And that is how this calculator also serves as an NPS Pension Calculator or an NPS Annuity Calculator which will clearly tell you how much Pension and tax-free lump sum amount you will get from NPS at retirement.
Like any other calculator, even this requires certain inputs from you. The NPS Calculator Inputs you need to provide are the following:
- Your current age (assumed you start investing at this age)
- Retirement Age – fixed here at 60
- Monthly NPS contribution
- The annual increase in monthly contributions
- Asset Allocation of NPS portfolio (to be provided for Equity, Government Bonds and Corporate Bonds)
- Lumpsum withdrawal at retirement (can be between 0% to 60%)
- Amount used for Annuity Purchase (can be between 40% and 100%)
- NPS Annuity Rate % during the post-retirement period
Now here is what the National Pension Scheme Calculator (or NPS calculator) calculates and shows as Output once the inputs are provided:
- The total amount invested (contributed) during the accumulation phase
- The total corpus accumulated
- The amount available as a one-time tax-free withdrawal
- The amount being used for Annuity Purchase
- Monthly Pension Amount during retirement years
Once you use this tool, you will have a very clear idea of how NPS works with example. Here is the link where you can find the calculator:
You can use this calculator to estimate how much money you can save using NPS. But let’s take a simple example of NPS Corpus calculation.
As mentioned earlier, many people invest Rs 50,000 per year in NPS just for the tax benefits. But I think if you are investing in this product, the more important question to ask is that what would be the Retirement Corpus & Pension for investing only Rs 50,000 per year in NPS?
So let’s see what would be the final corpus and pension if Rs 50,000 invested in NPS Tier 1 account every financial year till the age of 60?
Before we run the numbers and kind of simulate the NPS Annuity Calculator, we need to understand the latest NPS withdrawal rules:
- Minimum 40% of the NPS maturity proceeds (corpus) must be used to purchase an annuity plan. This 40% isn’t taxed. But, the income (or pension) generated from the annuity will be taxed at the then tax slab rate of the retiree.
- The remaining 60% is exempt from tax and can be withdrawn as a lump sum.
- If they want, then NPS retirees can use more than 40% (up to 100%) of the NPS corpus to purchase the annuity. In that case, the lump sum available will decrease accordingly. For example – one may choose to purchase the annuity plan using 65% of the NPS corpus on retirement (instead of the required minimum of 40%). He will then only get remaining 35% as a one-time lumpsum tax-free payout.
So according to NPS rules, basically, there is no tax at the time of withdrawal at retirement as i) 40% goes towards annuity purchase tax-free and ii) remaining 60% is paid out immediately as a tax-free amount. The only time any tax has to be paid is on the income being generated from the annuity in later years.
Before we do NPS Maturity & Pension calculations for 2020, let’s make a few assumptions:
- NPS Starting Age – 25 / 30 / 35 / 40
- Retirement Age – 60
- Investment Tenure – 35 / 30 / 25 / 20 years (as starting age is different but retirement fixed at 60)
- Annual NPS investment – Rs 50,000 only
- Does investment amount increase every year – No
- Expected Returns – 10% (assuming a balanced mix of equity and debt)
- Part of the NPS corpus used for Annuity purchase on retirement – 40%
- Part of the NPS corpus used for Lumpsum Payout – 60%
- Annuity Rate at the time of retirement – 6%
So here are the results of calculating NPS maturity calculator and pension and more importantly to see how NPS works with example:
Start at 25 and Retire at 60 (35 years tenure)
- Total Contribution – Rs 17.5 lac
- Total NPS Corpus – Rs 1.49 crore
- 40% used for Annuity Purchase – Rs 59.6 lac
- 60% Lumpsum Tax Free Payout – Rs 89.4 lac
- Monthly Pension from Annuity – Rs 29-30,000 per month (before taxes)
Start at 30 and Retire at 60 (30 years tenure)
- Total Contribution – Rs 15.0 lac
- Total NPS Corpus – Rs 90.5 lac
- 40% used for Annuity Purchase – Rs 36.2 lac
- 60% Lumpsum Tax Free Payout – Rs 54.3 lac
- Monthly Pension from Annuity – Rs 18,000 per month (before taxes)
Start at 35 and Retire at 60 (25 years tenure)
- Total Contribution – Rs 12.5 lac
- Total NPS Corpus – Rs 54.1 lac
- 40% used for Annuity Purchase – Rs 21.6 lac
- 60% Lumpsum Tax Free Payout – 5 lac
- Monthly Pension from Annuity – Rs 10-11,000 per month (before taxes)
Start at 40 and Retire at 60 (20 years tenure)
- Total Contribution – Rs 10.0 lac
- Total NPS Corpus – Rs 31.5 lac
- 40% used for Annuity Purchase – Rs 12.6 lac
- 60% Lumpsum Tax Free Payout – Rs 18.9 lac
- Monthly Pension from Annuity – Rs 6300 per month (before taxes)
Note – These numbers are indicative, based on an assumed constant average rate of return of 10% and annuity rate India of 6% (which may not actually remain constant). The actual returns, final NPS pension, final lump sum amount one gets from NPS may be higher or lower.
And like in many other long term investment products, it’s pretty obvious that to make the most of the NPS, the subscriber should ideally start investing as early as possible. And if one increases the annual (or monthly) contribution towards NPS every year (in line with the increase in income), then that would make the final NPS Retirement Corpus even bigger and result in a higher pension in during retirement.
So now you have your answers to questions like what would be final NPS retirement corpus and monthly pension (income) in retirement years.
We discussed the rules of NPS Maturity briefly in the above examples. Now let’s have a detailed look on it.
NPS Maturity Exit Rules (Latest 2020 – Updated)
Here are the latest rules for exit from National Pension Scheme (NPS):
- When NPS subscriber reaches the age of 60 (or Superannuation), he will have to mandatorily use at least 40% of the accumulated NPS pension 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 corpus is less than Rs 2 lac, the subscriber can make 100% lumpsum withdrawal.
- NPS account holders are allowed to defer the purchase of Annuity (using minimum 40% of NPS Maturity corpus) for up to three years.
- The NPS lump sum withdrawal can also be postponed till a subscriber attains the age of 70 years. This rule was made to make it tax-efficient for subscribers to withdraw lump sum (when the old rule was 40% tax-free and 20% taxable lumpsum withdrawal). But since now entire 60% corpus is available for tax-free withdrawal, this option allowing postponement of lumpsum withdrawal is not of much use.
That was about when you exit NPS at the regular age of 60.
What is NPS Annuity?
This is a very important question.
And since eventually, all NPS subscribers will have to purchase an annuity for pension, it makes sense to understand what is NPS annuity and how does NPS annuity work.
To clear some confusion that people have. NPS does not provide an annuity.
NPS is used to accumulate a corpus. Out of this corpus, 40% minimum is to be used to purchase an annuity plan at the time of retirement. These annuity plans then pay annuity income (or pension) based on what is annuity rate in NPS in India the time of annuity purchase.
However, these annuity plans are not sold or managed by PFRDA or NPS Trust. Instead, the NPS annuity plans are sold by insurance companies which are empanelled with NPS as Annuity Service Providers (ASP). As of now, the following insurance companies are empanelled to provide annuity under NPS (National Pension System):
- Life Insurance Corporation of India
- SBI Life Insurance Co. Ltd.
- ICICI Prudential Life Insurance Co. Ltd.
- HDFC Standard Life Insurance Co Ltd
- Bajaj Allianz Life Insurance Co. Ltd.
- Star Union Dai-Ichi Life Insurance Co. Ltd.
- Edelweiss Tokio Life Insurance Company Limited
- India First Life Insurance Company Limited
- Canara HSBC Oriental Bank of Commerce Life Insurance Company Limited
- Kotak Mahindra Life Insurance Company Limited
You can also check NPS Trust’s website for an updated List of NPS Annuity Service Providers in India.
And when the NPS account matures, it is compulsory for NPS Subscribers to purchase an annuity product from empanelled ASPs at the time of Superannuation and Pre-mature exit. The NPS Subscriber selects the ASP at the time of submitting the withdrawal request or after the payment of Lump-sum withdrawal.
I know you would now be feeling that you know the complete answer to what is annuity in NPS and what is annuity plan in NPS.
But believe me. There is another interesting aspect to NPS annuity in India.
So to highlight the same, let’s see what annuity options are available when you go out to purchase an NPS annuity using a minimum 40% of NPS corpus?
There are several annuity plans which differ in the following aspects:
- Does the annuity pension income stop after death of Annuity buyer? Or it continues to go to spouse?
- Is the annuity pension income increasing or its constant over the years?
- Is the amount used to purchase the annuity returned after the death of the pension receiver or not?
On the basis of the above factors, there are many annuity options available. These are as follows:
- Annuity (Pension) at a fixed rate only till the life of NPS buyer.
- Annuity (Pension) at a fixed rate only till the life of NPS buyer and then after death, the full annuity purchase price is returned to nominee/spouse.
- Annuity (Pension) at increasing simple rate only till the life of NPS buyer.
- Pension at fixed rate till the life of NPS buyer. After death, 100% of the pension to be paid to the spouse until her life.
- Pension at fixed rate till the life of NPS buyer. After death, 100% of the pension to be paid to the spouse until her life. Plus Annuity purchase price returned on the death to the nominee.
So what is annuity period in NPS will depend on how long NPS pensioner survives and whether the pension is to be paid to surviving spouse or not.
To know more about the NPS annuity and ASPs, I suggest you go through this set of Annuity FAQs. It will give you more information about what is annuity in NPS (National Pension System).
Also to get an updated idea of what the actual annuity pension amount will be for a given NPS corpus, you can check current annuity rates of various ASPs here. It will show you what is annuity rate in NPS in India and how different Annuity Service Providers offer different Annuity rates India for people who wish to purchase an annuity using their NPS savings.
And to give you some idea, the current annuity rate in India can be considered to be about 6%. Though the actual rate of NPS annuity will differ on the basis of what age you purchase the annuity, which option you chose (amongst the ones discussed earlier) and a few other factors.
Didn’t we miss something?
Yes, we did.
How is the taxation of Annuity Income in retirement?
The answer is that the annuity pension income will be taxed in the year of receipt as per your tax slab and applicable tax rate.
And that is what is annuity in NPS and that is how NPS works after retirement.
Unlike EPF or PPF, where you get full corpus as a lump sum tax-free, the NPS forces you to purchase an annuity for a minimum of 40% of the corpus. Many will think that it is a shortcoming of NPS. But remember, NPS is designed to be a retirement pension product and not just a plain savings product. So NPS is doing exactly that.
An annuity gives periodic income for life to the retiree. And that can be a good thing for many people who don’t know how to generate regular income from a large corpus.
So that is the detailed answer to your questions about What is annuity in NPS and annuity rates India.
Now you have understood how to exit from NPS at maturity and how to get a pension income from the purchase of annuity product and how NPS pension is taxed.
But what if you want to exit from NPS prematurely and close the NPS account? And what if you want to withdraw partially from NPS account without closing it?
Let’s have a look at the rules for these situations:
Latest NPS Premature Exit Rules (2020)
- 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 corpus to purchase the annuity. Only the 20% or less remaining corpus can be withdrawn tax-free as a lump sum.
- In case of death of NPS subscriber before retirement, the nominee can withdraw the full accumulated amount as a lump sum. Though they have the choice to buy any of the annuities being offered if they so desire. In case of the government NPS, 80% of the accumulated corpus has to be used to buy an annuity and the balance is paid out to the nominees as a lump sum.
So now you know that if you do plan to use NPS as a retirement savings product but are exploring early retirement, then you need to remember that you will necessarily have to use 80% of NPS corpus to purchase the annuity.
Latest NPS Partial Withdrawal Rules (2020)
NPS partial withdrawal is different from NPS exit. The NPS withdrawal rules are for cases when the NPS account isn’t closed (as is done in Exit) and only partial withdrawals are made. These rules are applicable to Partial withdrawal from NPS Tier-1 accounts:
- Partial withdrawals can only be made from NPS, if the Subscriber has had 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 NPS. The limit of withdrawal is up to 25% of only the 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.
- The withdrawal 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.
- As for the Tier-II NPS account, there is no such limit or conditions attached on partial withdrawal from it. But the government employees who are claiming deduction under section 80C of the Income Tax Act on the Tier-II account will not have that flexibility to withdraw money from the Tier-II account before 3 years if they have claimed the deduction.
- Also, there are limits to how many times you can withdraw from NPS. 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.
As a side note, be reminded that most of the limits and rules on exit and withdrawals from NPS are specifically for NPS Tier-I account. If you are a common citizen and have money parked in NPS Tier-II account, then you are free to withdraw as and when you require. But your contributions to NPS Tier 2 Account don’t qualify for tax rebate either. But for government employees, the contributions to the NPS Tier-II account are eligible for tax deduction under Section 80C up to Rs 1.5 lakh per annum, but there would be a lock-in period of 3 years. The returns on NPS Tier 2 account contributions are taxable at slab rates as applicable to the individuals.
The PFRDA’s site has a list of FAQs on NPS Exit and Withdrawals. You can refer to it if you wish to know more about it.
We earlier discussed a little bit about tax benefits in your NPS contributions. Now let’s analyse in detail the taxation aspect of NPS during various phases.
Latest Rules: NPS Tax Benefits (during Contribution)
Even though NPS is a pure retirement savings product, many people invest in it for the sole reason of getting an extra Rs 50,000 tax benefit. And these are the people who want to know how NPS works for tax benefit. There is nothing wrong with taking tax benefits if available. But as I wrote earlier in investment planning is more important than tax planning, the reason to invest in NPS should be more than just tax saving. You need to pick the right product for the right financial goal first. Then comes the maximization of tax savings.
With that said, let’s see the latest tax benefits for NPS:
- 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 up to Rs 50,000 in a financial year is available for NPS 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.
- All these deductions are available on NPS Tier 1 accounts.
So if you are investing in NPS, then a total of Rs 2 lacs can be claimed as a deduction for own contributions in NPS. If your employer also contributes, then the tax benefit on employer contribution is in addition to the Rs 2 lac benefit on own NPS contributions.
And NRIs (or Non-Resident Indians) are also eligible for extra Rs 50,000 additional tax benefit on NPS.
As mentioned earlier, these tax benefits are available for contributions made to NPS Tier I account. But what about tax benefits on NPS Tier 2 accounts?
NPS Tier II tax benefits are now available only for the government employees. If the employee makes a contribution towards NPS Tier 2 Account and claims the tax benefits under Section 80C, then he will also have to have the invested money locked in for 3 years (like 3-year lock-in in ELSS Mutual Funds).
NPS Maturity & Withdrawal Taxation (Updated 2019-2020)
I have already written about this in detail at NPS Maturity Withdrawal Taxation earlier. But for the completeness of this discussion, here are the rules.
NPS Taxation At Exit (Retirement)
- 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 60% can be withdrawn as a lump sum.
- The amount used to purchase an annuity (minimum 40% but more can be used) is fully 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.
- The remaining 60% corpus (or less if more than 40% used for annuity purchase) is also exempt from any taxes.
So if you consider NPS as a retirement saving instrument, then like PPF and EPF, you don’t have to pay any taxes on exit from NPS at maturity (retirement). The amount (40% or more) you use to purchase annuity plan is exempt. The Lumpsum withdrawal (60% or less) is also exempt. So, your tax liability immediately from NPS on retirement is NIL. It is only that when you begin getting pension (annuity payments) that you will be taxed. Not bad if you can manage your taxes properly at retirement.
NPS Taxation At Premature Exit
- If someone wishes to exit NPS before 60 (retirement), then as per the latest NPS Premature Exit Rules, at least 80% of the accumulated NPS corpus is to be utilized to purchase an annuity. Only the remaining 20% can be withdrawn as a lump sum.
- The amount used to purchase an annuity, i.e. a minimum of 80% in this case is exempt from taxes. However, the annuity income (or pension) received from the annuity plan will be taxed as per your tax slab in the year of receipt.
- The remaining 20% corpus (or less if more than 80% used for annuity purchase) is exempt from taxes.
NPS Taxation At Partial Withdrawal (Without NPS Exit)
As per the latest NPS withdrawal rules, NPS permits limited partial withdrawals to be made under certain conditions. Withdrawals are allowed only to the extent of 25% of your own contribution (and not employers’) and that too only 3 times during entire NPS tenure. More importantly, these partial withdrawals are exempt from income tax.
Many people regularly compare NPS with PPF as both offer tax-saving benefits and are used for long term savings. And I have already written a detailed guide on Choosing between NPS vs PPF.
So lets briefly touch upon this aspect as well:
- NPS vs PPF: Returns Comparison: The PPF is a fixed-income debt-oriented investment product. That is, PPF has a fixed rate of return (%). And the exact interest rate of PPF is set every quarter. In recent years, the PPF returns have been around 8% per annum. But you can have a look at the detailed history of PPF Interest rates. The NPS allows investors to have an equity exposure of up to 75% in certain cases (though actual equity exposure depends on your NPS Auto Vs Active choice). But given the option of having a large equity exposure, NPS subscribers have a chance at getting higher returns. The NPS returns depend on the performance of NPS funds. And more specifically on the asset allocation chosen and actual performance of the Scheme E (NPS Equity Funds), Scheme G (NPS Government Bond Funds) and Scheme C (NPS Corporate Bond Funds) of NPS. So if you were to ask what or who decides the returns? Then for PPF, the interest rate is decided by the government while for NPS, returns are linked to the market and if the aggressive allocation is opted for, then potential returns can be higher.
- NPS vs PPF: Exit Rules at Maturity: PPF has tenure of 15 years. At maturity, that is after 15 years, the full PPF maturity amount is tax-free in your hands. You can also choose not to withdraw money from PPF and instead extend by 5 years. There is no limit on the number of extensions. So your PPF account can be extended beyond its original tenure of 15 years to 20 years, 25 year or even 30 years. If you want to know how much you can save using PPF, feel free to use this PPF Excel Calculator (Free Download). Or if it interests you, then you can even have a look at how to become crorepati using PPF. The latest NPS Exit Rules state that at maturity (i.e. at 60 or retirement) of NPS, you have to use at least 40% of the accumulated NPS corpus (Tier 1) to purchase an annuity plan. The remaining amount of up to 60% can be taken out as a one-time lump sum. And neither the 40% used for annuity purchase is taxed nor 60% lump sum is taxed. Only the annuity pension income is taxed in later years. But if you do not wait till 60 and decide to exit NPS before (like in case of voluntary retirement or early retirement), then minimum 80% of the accumulated NPS corpus has to be compulsorily used for the purchase of an annuity. Only the remaining 20% or less can be withdrawn tax-free as a lump sum.
- NPS vs PPF: Taxation At Maturity (Exit): Normal exit in case of PPF is considered after 15 years of account opening. Normal exit in case of NPS is considered at the age of 60 (or superannuation). So the actual tenure of NPS will vary depending on when the NPS account was opened. So if someone opens it at age 32, then normal NPS maturity happens after 28 years. But if someone opens an NPS account at age 47, then normal maturity happens after 13 years. After a 15-year tenure, the PPF maturity amount is 100% tax-free in your hands. If you extend it by 5 or more years, even then the maturity amount is tax-free in your hands as per current PPF maturity taxation rules. What about NPS Taxation at Maturity or Exit (Retirement)? As per the latest NPS Exit Rules, at least 40% of the accumulated NPS corpus is to be utilized for the purchase of an annuity at retirement. And the remaining 60% can be withdrawn as a lump sum. The amount used to purchase an annuity is fully 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. The remaining 60% corpus (or less if more than 40% used for annuity purchase) is also exempt from any taxes.
- NPS vs PPF: Annuity Purchase: Both NPS and PPF are retirement-focused products. To be fair NPS is pure retirement product while the PPF can be used to save for retirement as well as for other financial goals which have similar timelines. But there is no compulsion to purchase an annuity on the maturity of PPF. You get your full PPF to accumulate corpus tax-free and you are free to use it without restrictions. In NPS though, you have to use a minimum 40%of the accumulated amount to purchase an annuity plan. And if you exit before retirement at 60, then you will necessarily have to use at least 80% of NPS corpus to purchase an annuity plan.
- NPS vs PPF: Maximum Investment in a Year: This is an interesting discussion if you are looking to save more than Rs 1.5 lac towards your retirement savings. You can only invest up to Rs 1.5 lac in PPF in a financial year. Not more. And if you have multiple PPF accounts in family, then ideally speaking, this limit of Rs 1.5 lac is on all the account combined. And you can make a maximum of 12 contributions per year in a PPF account. What about NPS? There is no upper limit on the investment you can make in NPS every year. And this is what makes NPS useful for people with larger retirement investments. So the answer to the question ‘Can I increase my NPS contribution?’ is a resounding yes. You can invest a lot more in NPS than in PPF as PPF has a limit of Rs 1.5 lac per year.
- NPS vs PPF: Choice Where Invested: PPF is a pure debt product. So you have no choice or freedom there. Your money gets invested in debt and you earn what government gives you (PPF interest rates are revised quarterly). NPS is a more customizable hybrid retirement product. You can choose between equity funds, government securities fund and corporate bonds and fixed income instruments, alternative investment funds. You can choose from 7-8 pension fund managers. And most importantly, you can choose (if you go for NPS Active Choice) how much money is invested in equity and how much in debt, that is, you can pick your asset allocation yourself. So compared to PPF, NPS does offer a lot of flexibility in terms of asset allocation.
That is about the differences between NPS and PPF.
Another tax-saving investment option often compared with NPS is Equity-linked Savings Scheme (ELSS). I have written a similar detailed noted about the comparison of NPS vs ELSS.
So that was all about what is NPS and How NPS works. I know this ended up becoming a very detailed and long guide. But that was the idea. I had written about various aspects of the National Pension System (NPS) separately and wanted to put in place a combined resource. So this is it.
Now the final question which any person interested in the National Pension Scheme (NPS) would have is…
Should I invest in NPS?
You have seen in extreme details how NPS works before retirement and after retirement. It’s possible that you may be tempted towards it too.
Should I invest in NPS?
If yes…then How much should I contribute to NPS?
Before we try to address this important aspect, let us remind ourselves of the difference between how NPS works for government employees and how NPS works for private employee. For the government employees, they don’t have an option to ‘not’ invest if their organization makes them invest in NPS. Right? So its more important for the private sector employees and professionals to understand about NPS as they have the ‘voluntary option’ to invest and aren’t forced to do it.
After having looked at NPS from all directions (in various sections above), one thing that must be remembered is that NPS is not a regular savings product. It is a product made for especially for retirement savings. That means that it is an investment product with a very long term investment horizon.
And you would agree that when it comes to investing and saving for the long term, I constantly talk about when having a high allocation to equity is the best option. There are numerous examples like this and SIP success stories that support this view.
So theoretically speaking, if NPS has high equity allocation in any of the choices we discussed, then it should be fine from a retirement savings asset allocation perspective.
So should you invest only in NPS for retirement?
Because when it comes to saving for retirement, there are many other products like EPF (Employee Provident Fund), VPF (Voluntary Provident Fund), PPF (How to become PPF Retirement Crorepati) and whatnot. And then, you also have the option of having some pure equity allocation using SIP in good Equity Funds to save properly for your retirement years.
And why SIP? Because among many options that are there for small investors, the SIP is small investor’s best bet.
Coming back to NPS, I think that its best to keep NPS’s asset allocation as a part of your overall strategic allocation for retirement savings. So if you are conservative investor, then NPS should also be conservatively deployed. On the other hand, if you are Aggressive Investor, then maybe NPS too should be deployed accordingly. But different situations may require different NPS strategies.
One more thing before we end. Many people just look at NPS in isolation only for the tax benefits. That is wrong. NPS does provide tax benefits but that is not the right reason to invest in it.
NPS is a long-term retirement-focused savings scheme. And when it comes to retirement and if you aren’t investing the right amount every month, your NPS corpus is not going to grow significantly to meet your entire retirement needs.
So instead of randomly trying to invest just Rs 50,000 in NPS every year to save more taxes, you should instead link the NPS investment to your overall retirement plan which should also contain SIP in good Equity Funds, EPF and PPF as well.
And please, do not let these facts be forgotten that –
- The cost of being wrong about retirement savings is catastrophic.
- Your children cannot be your retirement plan. No matter how much you love them and sacrifice for them.
- You need to save for your own retirement.
- And you will not get any loans for retirement either.
So you have deep-dived into What is National Pension System and how NPS works.
But before you chose any product like NPS for retirement planning, take some time out and find out what kind of retirement are you looking forward to? Is it regular retirement at 60 or early retirement?
Only then you should do proper Retirement Planning Exercise to find out how much you need to invest for a chosen retirement lifestyle. It’s only then that you should ask yourself or take help from Fee-Only Financial Planner whether you need to invest in NPS or not.
The government has done its bit to make NPS attractive by making it EEE (Exempt-Exempt-Exempt) now from the earlier EET (Exempt-Exempt-Taxed) status. But whether NPS fits in your retirement plan in 2020 or not is another question. And there are many other good products like EPF, PPF, NPS, Equity Funds & Debt Funds which can work very well for your retirement planning.
The most important thing for you is to ensure that you are able to save enough for your retirement. And NPS can definitely be a good product for your retirement. But it may or may not be suitable for everyone.
So in your interest and to ensure that you end up being a case of financially retirement failure, you need to properly identify which retirement savings products are the best suited for your unique needs and then invest in those products.
If you are unable to save for your retirement properly, do take help of fee-only financial planners who can solve your retirement maths alongwith creating a solid plan for all your financial goals (including retirement):
I hope you found this detailed guide on the National Pension System (NPS) useful. It contains all you need to know about NPS. But what I have tried is to highlight how NPS works with example and tried to assess National Pension System from various vantage points. It’s possible that I may have skipped some parts of the discussion to limit the length of this already super long post (sorry for that!). But before you go for retirement planning with the National Pension Scheme (NPS), it is very important to fully understand how NPS works and whether it is the right retirement savings product for you or not. Once you find it suitable, it’s only then that you should think about how to use NPS for retirement planning and for getting a regular pension from NPS annuity after retirement in 2020.