National Pension System (NPS)

What is the National Pension System and how does it work?

The National Pension System (NPS) is an investment scheme which provides subscribers an option to save money for the long-term. At retirement time, the accumulated money can be received in the form of regular monthly pension (also called Annuity) or it can be withdrawn in one lump sum payment (up to a certain limit).

The scheme is regulated by the Pension Fund Regulatory and Development Authority (PFRDA) and the ‘NPS Trust’ is responsible for safeguarding the assets of the subscribers. The scheme was first launched by the Government of India for the central government employees, with effect from 01 January 2004.

Many state governments then followed and implemented the scheme for their employees in subsequent years. So, the launch dates for the state government employees depends on the State in which they are working.

Starting from Financial Year 2009-10, the scheme was made available for all individuals who are citizens of India (including NRIs). The subscribers should be between 18 to 65 years at the subscription time and the subscriber needs to attain an age of 60 years, before he/she can start receiving the pension (except NPS Vatsalya). The accounts can only be opened individually and it is not possible to open joint accounts with multiple family members.

How does NPS work?

The National Pension Scheme has been designed to help the individuals in doing systematic savings for their retirement. When registering for this scheme, the subscribers are issued a unique Permanent Retirement Account Number (PRAN). The subscribers then save money in this retirement account in their employment years. Let us understand the working of NPS scheme with an example.

Example 1: Suppose that an employee subscribes for this scheme at the age of 30 and regularly makes the following monthly contribution for the next 30 years (till the age of 60 years): Self-contribution of INR 5,000 + the employer contributes another INR 5,000.

The total amount accumulated over the years will be:
(INR 5,000 + INR 5,000) x 12 months x 30 years = INR 36,00,000

In our example, the total amount accumulated till the age of 60, is INR 36,00,000 (INR 36 Lakh). At retirement, the subscriber can withdraw a part of this amount in lump sum mode and use the remaining amount to purchase an Annuity plan.

For example, suppose that the subscriber withdraws INR 16 lakh in lump sum at retirement, and uses the remaining INR 20 lakh to buy an Annuity, from an Annuity Service Provider (ASP). The ASP will then pay monthly pension to the subscriber, for the rest of his/her life.

Of course, the amount received as pension will depend on the amount given to the ASP. This means that an INR 1 crore (INR 1,00,00,000) Annuity plan will pay a higher monthly pension than an INR 20 Lakh plan, for example.

NPS scheme - national pension system working

Market linked returns

A unique feature about the NPS scheme is that the amount contributed by the subscribers in their account, will be invested in financial assets like stocks, bonds, government securities etc. So, the total accumulated amount is expected to grow due to the investment returns generated over the years.

Example 2: In example 1, we saw how INR 1,20,000 deposited every year, for 30 years will accumulate to INR 36,00,000 (INR 36 Lakh). Let us assume that the INR 1,20,000 deposit of every year is invested for the remaining duration and no money is withdrawn for 30 years.

Due to the magic of Compounding, the total accumulated amount will be much higher than INR 36 lakh. For reference, the total amount in different scenarios will be as follows:
(Assuming annual rate of return and annual compounding of the amount)
At 4 % return: INR 69,99,400.23
At 7 % return: INR 1,21,28,764.96
At 10 % return: INR 2,17,13,210.99

It should be clear to the subscribers that the total accumulated amount will have a huge dependency on the investment returns that can be generated across the years.

Choosing investment schemes

When opening a NPS account, the subscribers have to select a Pension Fund Manager (PFM) that will be responsible for investing the money of the subscriber. The PFMs run multiple Pension Fund schemes, that invest in different asset classes. When the subscriber contributes money to their account, the PFM allots them units of the Pension Fund scheme. This is very similar to how the Mutual Funds allocate units to the investors.

So, subscribers need to do proper research and select a PFM and the schemes that they would like to invest in. Depending on the factors like age, risk tolerance etc., the subscribers have to choose a percentage contribution for each scheme. It is also important to understand that some schemes can be more volatile than the others.

Example 3: Suppose that a subscriber has set the preference as following: 50% in G scheme (government securities), 30 % in C scheme (corporate bonds), 20 % in E scheme (equity).

Now, let us assume that the subscriber contributes INR 10,000 to their account. The PFM will receive this money and it will allocate units from 3 different schemes to the subscriber:
G scheme: Units worth INR 5,000 (50 % of 10,000)
C scheme: Units worth INR 3,000 (30 % of 10,000)
E scheme: Units worth INR 2,000 (20 % of 10,000)

If the subscriber is not comfortable to choose the percentage share by themselves, then they can opt for ‘Auto Choice’ of fund allocation. Under the ‘Auto Choice’ option, the PFM automatically distributes the money based on the age and risk tolerance of the subscriber.

So, if for example, a subscriber is above 50 years and has a conservative nature, then the PFM will invest majority of the money in government bonds. To view the detailed information about how to allocate funds, refer: How to set and change scheme preference in NPS?

Tier 1 account vs Tier 2 account

There are 2 types of accounts that can be opened under this pension scheme: Tier 1 and Tier 2. The Tier 1 account is the normal account which has to be mandatorily opened when subscribing to the scheme. On the other hand, a Tier 2 account is a voluntary account for saving money, in addition to the Tier 1 account.

The subscriber has the option to open either a Tier 1 account or a Tier 1 + Tier 2 account. It is not possible to just open a Tier 2 account. Similarly at the closure time, if the subscriber decides to close the Tier 1 account, then the Tier 2 account will be closed as well. (Refer: How to open Tier 2 account in NPS?)

The main difference between the two accounts is in the withdrawal restrictions and the tax benefits. Since it is expected to be used for retirement planning, many restrictions have been placed on withdrawing funds from a Tier 1 account. Whereas, the withdrawals in Tier 2 account are permitted at any time (except for the NPS Tax Saver scheme in Tier 2).

All the Pension Fund Managers (PFMs) run different fund schemes for a Tier 1 and a Tier 2 account. To understand the difference between these two in detail, refer: What are Tier 1 and Tier 2 NPS accounts?

Withdrawal from NPS account

To encourage subscribers to save money for the long-term, there are some conditions put in place for Tier 1 accounts. In case of Tier 1 accounts, the full amount can be withdrawn only in the following scenarios:

1. Superannuation (Attaining the age of 60 years)

If the total accumulated amount at the age of 60 years is less than INR 5,00,000 (INR 5 Lakh), then 100% of the amount can be withdrawn in a lump sum payment.

If the amount is greater than INR 5 Lakh, then the subscriber has to use at least 40% of the amount to purchase an Annuity plan. The remaining amount can be withdrawn in lump sum mode.

If the subscriber does not wish to withdraw the money at the age of 60, then the subscriber can stay invested and defer the payments up till the maximum age of 70 years.

2. Pre-mature withdrawal

Premature closure of account before retirement can only be done if the subscriber has completed at least 10 years in the scheme. If the total accumulated amount is less than INR 2,50,000 (INR 2.5 Lakh), then 100% amount can be received in a lump sum payment.

But if the accumulated amount is greater than INR 2.5 Lakh, then at least 80% of the total amount has to be used to purchase an Annuity plan. The remaining 20% amount can be withdrawn in a lump sum payment.

3. Death of subscriber

In case the subscriber passes away, then the total accumulated money till date, is paid in full to the registered nominee or the legal heirs of the subscriber.

Partial Withdrawal from NPS

PFRDA allows the subscribers to partially withdraw funds from their account in some pre-defined conditions like higher education of children, purchase/construction of residential home, medical treatment etc. (Please refer PFRDA website for the complete list of conditions).

However, this type of partial withdrawal can only be done if the subscriber has completed at least 3 years in the scheme. Also, such partial withdrawals are only possible for a maximum of three times during the entire subscription period.

The maximum amount withdrawn at each time cannot exceed 25% of the total contributions made by the subscriber. The investment returns and employer contribution are not included when calculating the 25% threshold.

Withdrawal from Tier 2 account

The Tier 2 accounts are much less restrictive and money can be withdrawn in full or in part, at any time. However, there is a restriction on withdrawal when a subscriber invests in the Tax Saver Scheme (NPS-TTS) in the Tier 2 account. The investments made in this particular scheme are locked-in for a period of 3 years from the date of investment (except in case of death of the subscriber).

The subscribers can also transfer the funds from their Tier 2 account to the Tier 1 account. In case a subscriber closes their Tier 1 account, then the Tier 2 account will also be closed automatically. But if any money is locked in the NPS-TTS, then that will only be released after the completion of 3 years. Funds from all the other schemes under Tier 2 can be withdrawn at any time.

Tax benefits under NPS

The tax benefits in the National Pension Scheme can be claimed on 2 occasions: at contribution time and at withdrawal time. To promote the scheme, the Government of India has provided many tax exemptions for subscribers and employers.

At contribution time, the following benefits are available:

  • Employee self-contribution: Up to 10 % of salary (Basic + DA) is deductible under section 80CCD(1). This is included within the overall limit of INR 1,50,000 (INR 1.5 Lakh), under section 80CCE in old tax regime.
  • Employee self-contribution: An additional amount of INR 50,000 is deductible under section 80CCD(1B), for the contribution made by the subscriber in the old tax regime.
    This is on top of the INR 1.5 lakh deductions made under Section 80CCE and the benefit can be claimed even if no NPS contribution was made under section 80CCD(1).
  • Employer contribution: If the employer supports NPS payments, then the employer contribution of the following amount is deductible under section 80CCD(2):
    Old tax regime: Up to 10% of salary (Basic + DA)
    New tax regime: Up to 14% of salary (Basic + DA)
    This limit is 14% for the government employees in both the tax regimes. The deduction is on top of the deductions made under Section 80CCE and 80CCD(1B).
    The benefit is available in both the new tax regime and the old tax regime. However, there is a ceiling limit of INR 7.5 lakh for the employer contribution in NPS + PF (Provident Fund).
  • Self-employed individuals: A contribution amount which is up to 20% of the gross income, is deductible under section 80CCD(1). This is included within the overall ceiling of INR 1.5 Lakh, under section 80CCE in old tax regime.
    In addition, INR 50,000 is deductible under section 80CCD(1B) in old tax regime. This INR 50,000 is on top of the deductions made under Section 80CCE and it can be claimed even if no payment was done under section 80CCD(1).

Similarly at withdrawal time, the following tax benefits are available:

  • Lump sum withdrawal: If the amount withdrawn at account closure time is up to 60% of the total accumulated investment corpus, then it is exempt from tax under section 10(12A).
  • Purchasing Annuity: Any amount paid from the NPS corpus towards the purchase of an Annuity plan is fully exempt from tax.
    However, the monthly pension (Annuity) that will be paid is taxable in the hands of the subscriber. This means that it will be treated as the income for that month. So, the tax slab rates will be applicable on the pension payments.

Tax benefit for Tier 2 account

There is a small benefit available for only Central Government employees under the Tier 2 account. If the subscriber invests in the Tax Saver Scheme (NPS-TTS) of the Tier 2 account, then the contributed amount is deductible as part of the overall ceiling of INR 1,50,000 (INR 1.5 Lakh), under section 80CCE in old tax regime.

But the money will be locked-in for 3 years, from the investment date. This scheme is only available for central government employees and there are no special tax benefits in a Tier 2 account for normal individuals.

To understand in detail about the calculation of tax exemptions under Tier 1 and Tier 2 accounts, refer: What is the tax benefit of NPS scheme?

Subscribing for NPS

A subscriber can open only 1 NPS account at any given time, but it is possible to have 1 account for NPS and another account for Atal Pension Yojana (APY). There are primarily 2 ways to register for the scheme:

  1. Offline mode (through a Point of Presence (POP) or a POP Service provider (POP-SP))
  2. Online mode (eNPS account)

For the detailed steps to open a new account online, refer: How to open NPS account? When completing the activation process, the subscriber has to pay an initial contribution amount to activate the account. Once the PRAN is active, then the subscriber can make additional contributions over the years, by themselves or through their employers.

Moreover, the subscriber can decide if he/she wants only a Tier 1 account or a Tier 1 + Tier 2 account. It is possible to have a different Pension Fund Manager (PFM) and scheme preferences for the 2 accounts. To understand in detail about adding money to the account, refer: How to make contribution to NPS account?

Disclaimer

  • This page is for education purpose only
  • Some information could be outdated / inaccurate
  • Investors should always consult with certified advisors and experts before taking final decision
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