Monday, March 23, 2015

The new NPS rules and tax-saving instruments in general

The recent budget has announced enhanced limits for National Pension Scheme (NPS) under section 80CCD of the Income Tax Act. It is possible to invest in NPS, along with other schemes under section 80C like PPF, NSC, etc. for the full limit of 80C, i.e. rupees 1.5 lakh. Apart from this, under section 80CCD(1B), an additional 50,000 can be invested in NPS to get tax breaks similar to section 80C.


The underlying provisions in summary: the amount(s) invested under Section 80C are allowed to be deducted from total income before tax is computed, thus effectively giving a tax break to any individual tax payer, amounting to his marginal tax rate. For example, if you are earning more than 10 lakhs per annum as taxable income, your tax will be in the 30 percent slab; if your taxable income is between 5 lakhs and 10 lakhs per annum, you will be in the 20 percent slab (I am ignoring surcharge here).  The amount you invest under 80C is deducted from your above total income before tax is computed thus giving you an effective exemption of your highest marginal tax rate.


Is investing in NPS worth it, with or without the enhanced limit?


Before answering that, let us look at 80C options in general. The limit of Rupees 1.5 lakh under section 80C apples to:

1)      Your contribution to company PF (which anyway is compulsory, and deducted every month)

2)      Children's school fees (which, if you have school-going kids, you anyway pay)

3)      Life insurance premiums for self and family (which, if you are paying, is anyway something that already exists)

4) The principal portion of your housing loan EMI


All the above "investments" along with others like PPF, etc. go towards calculating the limit under 80C. Let us assume Rupees 80,000 is anyway already accounted for under the above heads. What is left for 80C investment (in order to claim tax exemption under 80C that is) is only rupees 70,000.


For this 70,000 there are various contenders:


1)      PPF – debt instrument, interest rate 0.25 percent above "long term" rates, to be announced every year. This is "EEE" – Exempt on investment (i.e. 80C tax break), the interest earned every year is exempt, and the withdrawal is totally tax exempt. The lock-in is effectively six to seven years, since withdrawals based on a certain formula is possible from the sixth year onwards.   If you want to consider debt options for 80C, this is the best.

2)      National Savings Certificate (NSC), Kisan Vikas Patra, Bank Fixed Deposits: With lock-ins ranging from five to six years. However, the annual interest (interest accrued annually, even in case of FD's where total amount is only withdrawn only on maturity) is taxable, and has to be added to the taxable income for the year. These are clearly inferior to PPF and should be ignored.


3)      Equity Linked Savings Schemes: Certain mutual funds which invest only in equities are qualified as "ELSS" schemes. These are regular equity funds; the investments are EEE, and the lock-in is only three years. In case you want to invest in Equity for your 80C, this is the option.


4)      The new "Sukanya Samruddhi etc. etc." scheme. This is also EEE; it is a debt scheme; and the lock-in provisions are complex: effectively, 0.5 percent more than PPF every year, but with more onerous lock-in conditions. The fact that it is linked to your daughters' wellbeing, etc., is a good marketing tool, but should not be influencing your investment decisions. There is a case for looking at this for investments under 80C, since the interest rate is higher than PPF; however, the more onerous lock-in conditions offset that advantage to some degree.

Looking  at the complex nature of the scheme, I would prefer to avoid it, and stick to PPF and ELSS. However, that is a personal bias, since I hate complexity of any kind.


Hence, the real options under 80 C, for the amount that remains, after your PF, children's fees, and life insurance premiums are deducted from the 1.5 lakh, are only PPF (for debt) and ELSS (for equity). In case you want, the "Sukanya" scheme can be looked at as another contender.  All other options are inferior to these.


Where does the NPS have a place under the above scheme of things? NPS is also an allowed option under the 80C limit. However, NPS is an EET, scheme, meaning the initial contribution is exempt under 80C, the yearly accruals are exempt; however, at the time of final withdrawal, it is taxable. What the government giveth in your earning years, the government taketh away when you most need the money, after you are retired!  Hence NPS is to be avoided under the 80C limit of 1.5 lakh – it offers no real advantage over ELSS and is inferior in terms of tax treatment.


What about utilizing the "extra" 50,000 limit to invest in NPS. Again, that is not advisable.  The amount at the time of withdrawal is taxable, which makes it not worth considering.  Also, NPS has some detailed provisions on what can be done to the corpus after you turn 60; how much can be withdrawn as lump-sum and in what manner, and how much is to be converted to an annuity, etc. 


Until NPS gets into the EEE category, it is better to avoid it entirely.

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