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The 40% Problem When You Invest In National Pension (NPS)


Many people are attracted towards NPS (National Pension System) primarily for one reason... EXTRA TAX SAVINGS.

Firstly, you can invest an 'additional' amount — over and above the Rs.1.50 lakhs limit u/s 80C — in the NPS and claim extra tax deduction of up to a sum of Rs.50,000 per year; giving you a total deduction of Rs.2 lakhs.

Secondly, your employer can contribute up to 10% of your salary (Basic + DA) in the NPS. This contribution from the employer is NOT INCLUDED in your taxable income for the year.

This, double tax savings bonanza, is quite tempting indeed. More importantly, this tax incentive is specific to NPS only, and not available for any other investment/income.

Plus, of course, you don't have to worry about whether your savings will last your lifetime or not. There's the comfort of guaranteed, safe and assured income after retirement till the very end of your (or even your spouse's) life. You can sleep peacefully, knowing that you will never run out of money.

However, there's one major issue that has not received people's due and adequate attention.

And that could turn out to be a serious problem post-retirement:

As you would be aware, on retirement you are ALLOWED to WITHDRAW maximum 60% of the accumulated corpus. The balance 40% will be LOCKED-IN in an Annuity Plan FOREVER.

It is this 40% that requires a deeper analysis.

Let's take a simple example:

Suppose, you invest Rs.50,000 additional amount every year in the NPS for tax-saving purposes. There is no employer's contribution.

Time till retirement: 20 years
Average return during accumulation: 10% p.a.
Annuity rate of return: 6% p.a.

If that be so, you would have invested Rs.10 lakhs over 20 years. The accumulated corpus after 20 years would roughly be around Rs.30 lakhs. Of this,
(a) you could withdraw 60% i.e. Rs.18 lakhs (TAX-FREE) and
(b) the balance 40% i.e. Rs.12 lakhs will compulsorily be invested in an Annuity Plan, which will give you an income of around Rs.72,000 p.a. (TAXABLE).

1st problem: Merely tax deferment
Effectively speaking, you saved tax on Rs.50,000. But now you will have to pay tax on Rs.72,000. Assuming, your tax bracket remains the same, you would be worse off by investing in the NPS.

Instead, if you saved this Rs.50,000 in say hybrid funds, you will not get any tax benefit now. But, your withdrawals would attract very little or no tax at all, due to the indexation benefit on the long-term capital gains.

So, the question you need to answer is:
Would you like to
a. Save Tax Now (in NPS) and Pay Tax Later (in Annuity)
b. Pay Tax Now (on a smaller amount) and Save Tax Later (on a bigger amount)?

2nd problem: Low Returns
Typically, the rate of return in an Annuity Plan is quite low...in fact, lower than even the prevailing bank FD rates.

Whereas debt funds will, in all probability, deliver somewhat better returns than the bank FD rates.

So, even on a pre-tax basis, there is a strong likelihood of earning below-par returns FOREVER if you take the NPS-Annuity route. And, if you account for the annuity pension's tax inefficiency, the gap increases further.

Earning such low returns, year after year for decades, is most definitely a serious issue.

Besides, Rs.72,000 p.a. means just Rs.6000 per month. This, 20-30 years later, won't buy you even a day's groceries. So NPS alone cannot be the answer to your Retirement Planning. You have to think of alternatives too.

3rd problem: Fixed return forever
The rate of return, applicable at the time of buying the annuity, will not change throughout the lifetime. You (your spouse) will receive the SAME AMOUNT year after year for probably decades.

Therefore, you will NOT get the benefit of any increase in the interest rates thereafter.

Of course, you are also protected against the risk of falling interest rates.

If the rates are at historically high levels, maybe it's fine if the returns are fixed forever. But, if the interest rates are low (as at present), this would be a serious issue.

4th problem: Zero Liquidity
You have NO ACCESS whatsoever to this Rs.12 lakhs. Annuity plans do not allow premature withdrawal at all. (Depending on the type of annuity plan you choose, there would either be no return of principal amount, or your nominee will be returned the principal amount after your death.)

If you retire at say 60 and live till 80-85, you have around 20-25 years of post-retirement period. This is too long a time period. Anything can happen in these 2-3 decades. There could be any number of reasons when you would wish you could withdraw at least some amount.

Maybe you need to finance your children’s education.
Maybe you have a critical illness in the family.
Maybe you move to your hometown and have to buy a house.
Maybe you need capital to start a business post-retirement.
Maybe you have settled abroad and would like to shift all your investments out of India.

You cannot depend on the Annuity Plan to bail you out in these difficult circumstances. It will not give you even a SINGLE rupee out of YOUR corpus.

This loss of access to a fairly large part of the capital is another issue, which has not been given deep thought.

And, if we add employers' contribution to this, the problem becomes enormous.

Say, in addition to your Rs.50,000 additional investment, the employer too contributes Rs.50,000 to the NPS. In which case, the amount locked-in in the Annuity would be around Rs.24 lakhs. And, while you save tax on Rs.1 lakh now, post-retirement you will have to pay tax on around Rs.1.44 lakhs.

The more the investment, the bigger the problem.

Don't be lured by the additional tax saving offered by the National Pension System. In fact, it's not tax saving, it's merely postponing the tax liability (unlike say EPF, which is a genuine tax saving).

Don't be lured by a lifetime of assured income offered by the Annuity Plan. The post-tax returns will be much below par.

And, as discussed, NPS alone would be totally inadequate. You would need other options too for a comfortable and stress-free retirement. If that be so, why even think of NPS, given its multiple problems?

You can do a much better job yourself, without any serious efforts or requiring any serious financial knowledge.

Think about it. Seriously.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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