One of the most important aspects of financial planning to taking care of your retirement – building a sufficient corpus to meet your expenses and help you tide the ups and downs during the twilight years.
In order to help the general public be able to build a sizeable retirement corpus, the government introduced the National Pension System (NPS). Under this system, a defined contribution is invested in a mix of assets and the return from those assets help generate income for the post retirement corpus. The returns from the NPS are market-linked and dedicated fund managers undertake the task of managing this retirement money.
But how does NPS work?
Under NPS, an investor can opt for either of two accounts – A Tier 1 or a Tier- II account. The first one is where the retirement funds are non-withdrawable and permanent while the other is a voluntary withdrawable account.
A Tier II account can only be opened if you have an active Tier- I account. The minimum contribution for a Tier I account is Rs 500 for all transactions and Rs 6000 for a year. For the Tier II account, the minimum contribution for opening an account is Rs 1000 and Rs 250 is charged for subsequent transactions.
Choice of investing
An investor in NPS also has the choice of investing via either Auto or Active investing. Under the auto choice, the funds are invested based on a predetermined formula as per the age of the investor. The allocation is made in 3 asset classes: Equities, Corporate Bonds and Government Securities.
Under Active investment the investor can choose the allocation of retirement funds into the three asset classes. There is a limit of a maximum of 50% allocation in Equities. For the government sector, the cap on equity is increased to 15%.
Post retirement, an investor can exit from the NPS but 40% of the pension lump sum has to be utilised for purchasing an annuity. Upon withdrawal before the age of 60, 80% of the pension lump sum needs to be utilised to purchase an annuity.
These conditions apply only to the Tier-I account.
Taxation and expenses
Contributions made to the NPS account and the returns earned on investments of the retirement corpus are not taxed. However, a pension lump sum withdrawn on exit from the NPS is taxed, excluding the amount used to buy annuity.
The fund management charges on the NPS is also very low – just 0.01 per cent. This helps in the pension fund growth without eating into the returns.
Thus, NPA offers several benefits for long term retirement planning, offering income tax benefits apart from diversification of investments into asset classes. Those who do not wish to actively manage their portfolio until retirement age tend to find NPS attractive.