Does this tax loophole in National Pension Scheme help it trump mutual funds?

While NPS Tier-1 offers tax benefits but restricts withdrawals, Tier-2 offers flexible withdrawals without tax benefits.

Mutual funds command an asset base of ₹67 trillion. The NPS Tier-1 account has an asset base of ₹2.28 trillion, excluding contributions by state and central government employees. Meanwhile, the NPS Tier-2 accounts for just ₹6,510 crore.

Mint spoke with Kurian Jose, chief executive of Tata Pension Fund, to understand what makes the NPS Tier-2 attractive. Edited excerpts:

Some people are investing in the NPS Tier-2 to build a retirement corpus. Why is that?

Investors have broadly three options when it comes to retirement planning. The first is to invest in mutual funds, which invite capital gains tax at the time of redemption. The second option is to invest in NPS Tier-1 and get tax benefits. The NPS Tier-1 falls under the Exempt-Exempt-Exempt, or EEE, category from a taxation perspective. It means that contributions, accumulations, and withdrawals are tax-free. However, it comes with the condition of being unable to withdraw funds before 60, except for some grounds defined by the Pension Fund Regulatory and Development Authority. Investors can withdraw 60% of the corpus when they retire at 60 without any tax incidence, and the remaining 40% has to be invested in an annuity scheme that provides regular cash flow. The tax must be paid on the periodic pension (cash flow) they receive through this annuity purchase at their respective tax bracket.

The third option is the NPS Tier-2. Let’s say you are already contributing some money to the NPS Tier-1 but still have some money left. You want to put this money aside for retirement but, at the same time, don’t want to keep it locked. Who knows what life can throw at any point? In this case, you can either put the extra amount in mutual funds or invest in Tier-2 funds. 

The biggest drawback of Tier-2 funds is that they are taxed at the slab rate, which is higher than the capital gains tax rate in most cases. In terms of liquidity, both Tier-2 funds and mutual funds can be redeemed anytime. However, mutual funds have a favorable tax treatment and that seems like the better option. 

However, here’s the catch. You can convert your Tier-2 funds into Tier-1 funds before you turn 60. That way, you don’t have to pay any tax when you take out 60% of the corpus, and the rest is compulsorily invested in annuities. And in case you need that money, there is an option to exit early without any hassle, albeit at a higher tax rate based on your income slab rate applicable.

How would that math work?

Let’s say you invested ₹10,000 every month for 10 years. Assuming a 12% annualized rate of return, you would have a corpus of ₹22,19,300 at the end of 10 years. In 10 years, you would have invested ₹12,00,000 and received ₹10,19,300 as gains. If you had invested this money in equity mutual funds, then you would’ve paid a 12.5% tax on the capital gains, which is ₹1,27,412. This brings down the return to only 10.87%. If you had put this money in a Tier-2 account, you could transfer the corpus into a Tier-1 account. That way, you could redeem 60% of the corpus ( ₹13,31,580) without paying any tax. The remaining 40% has to be compulsorily invested in an annuity plan and tax needs to be paid on that periodic pension as per slab rate. There is also an option to let the 60% corpus compound further until you turn 75 if you don’t need that money immediately.

Does it make it better than mutual funds?

While the above shows one advantage of Tier-2 funds over mutual funds, there are other aspects of investing besides just tax considerations. Mutual funds offer a much wider variety of funds and categories to choose from compared to the NPS. 

For instance, NPS investments into equity are limited to the top 200 stocks as per market capitalization and do not have any distinct categories. If an investor wants specific allocations to small- or mid-caps or certain themes, they can do it only through mutual funds. The same applies to the debt category, which has various categories in the mutual fund structure but only two categories to choose from in the NPS: Corporate bonds and government securities. 

Another aspect to look at is that if the investments in Tier-2 schemes are redeemed, then they are taxed at a higher rate than equity mutual funds at the slab rate. The exception here is debt funds, which are also taxed at slab rate in the mutual funds. That said, the NPS has a much lower expense ratio compared to mutual funds. The NPS also allows a subscriber to toggle once between equity and debt investment using active choice and systematically move from equity to fixed income using auto choice without any tax incidence. Though we may not advocate it, subscribers can potentially toggle between equity and debt four times a year without any tax incidence using active choice in the NPS.

So, what should investors do?

Investors could use mutual funds for short-term and goal-based requirements. This could be for the purchase of a home, travel, education, marriage, etc. The NPS should be used to invest in preparing for retirement. NPS Tier-1 funds help with asset allocation, low expense ratios, auto choice and active choice, professional fund management, and portability across pension fund managers and jobs, well-regulated along with tax benefits. 

NPS Tier-2 funds help with all of the above with the benefit of liquidity but no tax advantage, except when switched to NPS Tier-1, as mentioned above.