Is NPS More Attractive after Additional 20% Tax-free Component?
Moneylife Digital Team 14 December 2018
On Monday, finance minister Arun Jaitley announced changes to the National Pension System (NPS), increasing the total tax-exempt cover to 100% of the NPS maturity value from 80% earlier.
 
Prior to this change, 40% of the total was annuitized without paying tax, 40% could be withdrawn tax-free and only the balance 20% was taxable. By the way, it is not clear why even the taxable portion was treated as income and taxed at the slab rate and not as long-term capital gains. 
 
Even though the taxable component was only 20% of the NPS corpus at retirement, the quantum was high enough to push the taxable amount in the highest tax slab. This is one reason why the finance minister decided to allow exemption on the balance 20% portion as well.
 
How much more attractive has NPS become after this 20% has been made tax-free? According to our previous analysis, we did not find NPS good enough, even after considering the various additional tax-deductions offered on the salary contribution.
 
There are two problems with NPS. One, the return of NPS could be lower than actively-managed mutual fund schemes. Over a very long time, even a 2% difference in return amounts to a very substantial amount of money. 
 
Two, the saver is forced to put 40% of the NPS corpus at maturity in an annuity. This is a substantial amount which will earn low returns. And it is mandatory. Suppose your NPS corpus is Rs1 crore at retirement, Rs40 lakh would directly go toward purchasing an annuity product.
 
Currently, returns on annuities fetch pre-tax 6%, whereas, returns on government-sponsored products like Senior Citizen Savings Scheme and LIC’s Pradhan Mantri Vaya Vandana Yojana offer 8%+ returns to their investors.
 
We decided to quantify the effect of the recent changes in NPS vis-à-vis the older NPS rules for those in the 30% income-tax slab and, simultaneously, even compare it with the performance of investing in equity-linked saving schemes (ELSS) of MFs. This is what we found.
 
 
The above example shows that allowing total exemption on the NPS corpus will increase the post-tax retirement amount marginally. Importantly, it will do away with the hassles of calculating and paying tax on the withdrawn sum. However, equity MF schemes are more competitive in terms of performance, flexibility and taxation than NPS. 
 
Also, the withdrawal process of NPS is a nightmare. After enquiring with a couple call centre executives of CRA-NSDL, the record-keeping agency of NPS, about the (now) tax-free status of withdrawals, we were dumbfounded with the responses received. One of the call centre executives herself was unaware that NPS was now tax-free; another executive told us that 60% of the maturity value was taxable (correct answer is 20%).
Other than being up-to-date with the latest changes, we found that our main query – whether the 20% taxable portion of withdrawal is taxed at the slab-rate or as capital gains–also took the executives by surprise. We were told to consult a chartered accountant for the taxation aspect. On the other hand, the same executives are fluent in the various tax-benefits and the Sections of the Income-tax Act under which the tax-exemptions can be availed.
 
Senior journalist R Jagannathan has described his own journey of withdrawing from NPS in this article. He described the whole withdrawal process as “unnecessarily complicated and tiresome to the subscriber.”At retirement, when you want to spend a peaceful life, if you have to go through hassles of getting back your own money after savings for decades, it is not worth it.
Comments
Prodeepto Chatterjee
3 years ago
need a small help on how the discounted annuity cash flow was calculated. the maths at footnote is too confusing. a little \"human\" like explanation please.
Pratibha kamath
Replied to Prodeepto Chatterjee comment 3 years ago
annuity will generate returns at 6% p.a. (expected for 25 years) with return of principal. if you discount this cash flow at 8% (at par with other fixed income returns) the net present value is Rs1.61 crore in our analysis.
Shivram Ramakrishnan
3 years ago
The whole premise of the article lies in the assumption that ELSS will give better returns than NPS over the long run. As some one pointed out, the additional tax savings from investing in an NPS of 15K (assuming highest tax bracket) should also be considered in the above calculation - still returns from NPS will be lower considering the 200 bps difference in the annual returns. However, one key point to note is that ELSS can be sold any time, whereas NPS "forces" you to invest for the long term. This could be an important factor, considering the impulsive human nature. Most people who intend to invest over the long term using ELSS will panic during a stock market fall and either stop investing or withdraw their funds when the market recovers, negating all the long term benefits of compounding. From that perspective, an NPS may be a better alternative not withstanding the lower returns.
Ramachandran
Replied to Shivram Ramakrishnan comment 3 years ago
Yes,the main challenge with general investors is having the discipline and conviction to stay invested for 20-25 years inspite of market ups and downs and all scandals going around.we will end up being fence sitters loosing the power of long term compounding effect.After seeing pros and cons,I think NPS decision also has to be seen with respect to age one enters into NPS.

If some one enters around 48-50,it is only 10 years and with Tax benefit we get both for employers contribution-excluded from salary and hence tax free and 50 k from employee contribution,we can divide 33 % and get around 3 % saving per year till 60 years.Even if NPs with large cap and 50 % max return gives 10-11 % return, totally we get 14 % and it is worth it.since we cannot withdraw in between long term compounding also is taken care.Also at 50 + less exposure to equity and in large cap maybe a good strategy and it is designed in NPS.

The main problem is 40% annuity with only 6% return.we have to hope annuity return may increase in future or rules will change and trade off on returns for safety and secure returns post retirement.if someone has to enter NPS in their 30s and invest for 30 years,the tax benefit angle maybe negligible and tenure also is long and they can take a call.
radhakrishna nemani
3 years ago
The above analysis is good for young investors. But it has not considered the point, ₹50K invested in NPS has tax exemption beyond 80C. For middle aged investers in 30% tax slab that makes a major difference.
Arpita Padiyar
Replied to radhakrishna nemani comment 3 years ago
yes. I think the tax saved from investing in nps i.e 15k can be invested in mutual fund. also if employer contributes to nps you can see extra tax beyond 80c
Karthik S
3 years ago
One important thing you missed to consider:-

NPS has an exclusive tax benefit (apart from the 1.5 Lakhs 80CCD 1B for 50,000.
If I don't save 50,000 in NPS, I will get only 35000 post tax.
So if I save this 50000, I get immediate 42.85 % returns (15000) from the taxable 35000 amount (after paying 30% tax on 50000) I would be effectively able to invest in any other product for future returns.

Apart from this exclusive 50000 (80CCD(1B) ), I also get upto10% basic pay contributed by employer as tax free component into NPS since it is not included in the taxable salary at all.

Whenever these exclusive tax benefits for NPS is stopped by the Govt, I will stop saving in NPS.

I am 34 now. I don't know and can't guess what will be the taxation when I turn 60 in 2044.
So I am not bothered about the 40% annuity / 20% tax free component at all since there is going to be a lot of changes in the country in next 26 years.

Also - I don't expect the 'journey of withdrawing NPS' will be that much bad in 2044 as in today.
Abhishek Singh
Replied to Karthik S comment 3 years ago
Totally agree. Also, the return is less due to diversified portfolio (looks like 75% equity is assumed) which will result in lesser volatility, which means higher risk adjusted returns.
NILESH JAVRILAL NOLKHA
Replied to Karthik S comment 3 years ago
I think you have missed the point. Suppose if you save 15000 by investing in nps due to yourself being in highest tax bracket. Now suppose you invest in nps 65000 vs rupees 50000 in equity for next 25-35 years. Since nps is not as good as well managed equity, consider it gives 12 percent returns and well managed equity gives 14 percent. Even then 50000 of equity will surpass nps after 25-35 years.

Calculate this with 50000 of nps vs 35000 good equity contribution over next 25-35 years. Even if we assume better returns with equity by 2 percent as above, good equity investing will surpass nps, even after considering tax benefit .

The argument that it makes nps makes you save 42 percent at start is not logical, as we are looking what will happen even we invest that additional money into nps. Now suppose you smartly invest 50000 into nps and say that you will invest 15000 so saved in good equity. Even then returns will be less after 20-30 years of this combination, if you compare it with investing everything in well managed equity (even after taking out amount if tax saved).

Now all if this is assuming that well managed equity will give at least 1-2 percent better returns than nps equity options. This has been persistently seen though.
RAVINDHIRAN MUKUNDRAJAN
Replied to NILESH JAVRILAL NOLKHA comment 3 years ago
The problem in this argument is that very rarely someone stays with one fund for 35 years. Switches in NPS are tax-free, whereas one would need to pay tax for a mutual fund switch every time
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