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Tax benefit on NPS is all bogus and sham

As I have repeatedly cautioned, taxation is one of the biggest drawbacks of the National Pension System (NPS).

The Govt's intention was to create a social security system for the aam aadmi. However, the NPS designed is simply too complicated and convoluted. So it doesn't surprise me at all that few know about; and fewer invest in it.

Taxation too on NPS is rather complex. This article, therefore, is going to be a difficult one. But, I am challenging myself to make it as simple as possible.

And, for the benefit of your precious money, I request you to read it patiently... don't miss the Googly at the end!

(Note: This discussion is applicable to 'all citizens including the corporate sector' i.e. excluding the Govt. employees.)

As you are aware, tax laws are applicable generally on three instances.
One, when you make the investment.
Two, when your investment is in the earning phase.
And, three when you exit from the investment, either on maturity or prematurely.

In NPS accounts, there is no tax while your amount is earning returns. So we have to focus on the instances one and three only.

A. Tax rules on NPS when you make your investment
This is where we have the first complication.

Normally, any investment in a particular scheme has one specified limit. For example, the limit on PPF investment is Rs.1.5 lakhs or the limit on home loan interest is Rs.2 lakhs.

NPS offers THREE distinct investment limits... for deduction from your taxable income.

1. Tax deduction on "your" contribution to the NPS [Sec 80CCD(1)]
The maximum deduction allowed is 10% of your basic salary plus DA if you are an employee (or 10% of the gross total income for other tax payers).

This, however, falls within the purview of Sec 80C; which has an overall limit of Rs.1.50 lakhs. In other words, only Rs.1.50 lakhs would be allowed as deduction for all your specified investments / expenses put together such as PF, PPF, Insurance Premiums, Home Loan Principal, Tuitions fees, ELSS, Pension Plans, NPS, etc.

2. Tax deduction on "your employer's" contribution to the NPS [Sec 80CCD(2)]
In addition to the above, your employer can contribute a part of the salary to your NPS account and you can claim deduction of the same from your taxable income.

Herein too, the deduction should not exceed 10% of your basic salary + DA. But, unlike above, there is no absolute limit specified here. So it can be any amount, so long as it is less than 10% of basic+DA.

3. Tax deduction on "your" ADDITIONAL contribution to the NPS [Sec 80CCD(1B)]
Over and above the aforesaid deposits, you can invest another Rs.50,000 in the NPS and claim "one more" tax deduction for the year. This is an exclusive deduction for NPS only, introduced this year w.e.f. April 1, 2015.

In other words, you are eligible for tax deduction of 
a) Up to Rs.2 lakhs invested by you in NPS and 
b) Up to 10% of basic + DA invested by your employer.

Don't be conned all these multiple deductions available to you, to slash your taxes. As we shall see in the next section, Govt. could take back much more later, than what it offers to you today. And, in the end, you could end-up as a loser.

Tax Benefit on National Pension System (NPS) is a just a Big Illusion
B. Tax rules on NPS when you exit from the scheme
This is where many disasters lie.

When you exit from NPS on maturity (or prematurely)
- 40% (or 80% if it is an early exit) would be used to compulsorily buy you an Annuity Plan
- 60% (or 20% if it is an early exit) would be returned to you lump sum

And this is how, these will be taxed:

1. Money for Annuity
There is no tax liability on the amount that goes into the Annuity Plan. However, the pension that you receive from it every year, would be your "taxable" income.

Disaster 1: In NPS, I am forced to buy the "tax-inefficient" Annuity Plan. Instead, if I had the freedom, I could have invested this 40% money in more tax-efficient investments such as tax-free bonds or the debt mutual funds.

2. Money paid to you lump sum
This has two tax implications:

a) 100% amount is taxable, when the lump sum money comes FROM YOUR OWN CONTRIBUTION [i.e. 80CCD(1) and Sec 80CCD(1B)].

b) 33% tax-free and 67% taxable (if you get gratuity); or 50% tax-free and 50% taxable (if you don't get gratuity), for the lump sum money that comes FROM YOUR EMPLOYER'S CONTRIBUTION [i.e. 80CCD(2)].

Disaster 2:  The lump sum amount forced upon me is "taxable". Instead, the lump sum money received on exit from PF, PPF, Insurance or ELSS would have been "tax-free" (plus I would get the "full amount" back, and not just 60%). 

And, finally the BIGGEST TAX GOOGLY:

Disaster 3:Note that the ENTIRE AMOUNT (if it is from your contribution) i.e. investment + returns, is taxable; not just the returns. Even on the employer's contribution, LARGE part of original investment is taxable.

So, while you don't have to pay tax, when you invest in NPS every year; the same amount is taxed on exit.

In short, you DON'T SAVE tax in NPS. You merely DEFER tax in NPS.

The is very different from say NSC or 5-yr Tax Saving Bank FD or Senior Citizen Scheme. In all these, you pay tax "only" on the returns. The principal is never taxed... neither at the time of investment nor on exit. This is REAL TAX SAVING.

And this TAX DEFERMENT has a SERIOUS angle.

You may, at present, be in 10%, 20% or 30% tax bracket. But, when you receive a large lump sum amount in one year, you will most certainly be pushed into the highest tax bracket. Thus, it may so happen that you may pay only 10% or 20% tax now if you don't save thru' NPS, but quite likely pay 30% tax when you retire and exit from NPS. That is why, I had mentioned that Govt. may take back more than what it offers today.

In other words, exit from the National Pension System is a tax disaster because:
a) NPS is not a tax-saving, but a tax-deferment investment
b) 40% of our money get permanently blocked in tax-inefficient Annuity Plan
c) We could possibly end up paying lot more taxes later

Therefore, as we have a choice u/s 80C, it is obvious that we should totally AVOID NPS u/s 80CCD(1) and put our Rs.1.50 lakhs in PF, PPF, Insurance, ELSS, etc. 

In addition, it is a BIG NO to NPS even for the employer's portion u/s 80CCD(2) or the new section exclusively for the NPS i.e. Sec 80CCD(1B).


That was a tough one...

But the answer is short and clear... AVOID NPS. Or your money will all be lost in this maze of taxation.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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