It is a question that is always doing the rounds in various investment forums. At first look, the question may look relevant during a tax-saving season. The last quarter of the financial year, starting from January to March, is known as the tax-saving season in our country. However, a close look at the question would bring home the point that an average investor does not actually ask this question.
An ELSS or Equity Linked Saving Scheme is a mutual fund scheme that qualifies for tax deduction under Section 80C of the income Tax Act. An investor can invest in an ELSS and claim a tax deduction of up to Rs 1.5 lakh under the section. Most taxpayers get into the mutual fund universe via their investment in ELSSs. These tax saving schemes come with a lock-in period of three years.
NPS or National Pension System, on the other, is a government-sponsored pension scheme that allows employees and slef-employed to invest in it and claim tax deduction under Section 80CCD(1). NPS also qualifies for additional tax benefit of Rs 50,000 under Section 80CCD(1B). However, investors can withdraw from NPS only at the time of retirement at 60. Withdrawals before that discouraged: one can withdraw only 20 per cent of the corpus and the rest of the corpus should be compulsorily used to buy an annuity.
“With its extra tax-saving allowance, NPS is not comparable to any other instrument but it is problematic to investors on various levels. Some of them being the absence of liquidity and taxable returns,” says Gaurav Monga, a certified financial planner. “One might argue that ELSS is a better tax-saving instrument but NPS doesn’t have a competition from ELSS in the extra 50,000 space,” Monga adds.
However, despite the exclusive tax deductions, not many investment experts recommend NPS to their clients, “NPS gives you a tax benefit but on higher stakes. You can not withdraw your investments before you turn 60, you have a compulsory annuity, you will get moderate returns and then your returns will be taxed as well. All this together makes it a not very investor friendly scheme,” says Harish Barke, a certified financial planner.
At 60, investors can withdraw 40 per cent of corpus tax-free. S/he should use 40 per cent of the corpus to buy an annuity. The remaining 20 per cent can be withdrawn by paying tax or used to buy an annuity. Note, the annuity income is taxed as per the income tax slab applicable to the investor.
“Investors can withdraw before he/she turns 60 in specific cases, like child’s education, marriage etc. But the withdrawal can only be up to 50 per cent of your investment,” says Gaurav Monga. “An investor with such a long investment horizon is better off in an equity scheme,” Monga adds.
With that we come to the relevant question: is it better to pay tax and invest the money in a regular mutual fund scheme than investing in the NPS?
Let us assume that a 35-year-old person wants to invest in NPS for the extra tax-break of Rs 50,000 under Section 80CCD(1B). If she is in the tax bracket of 30 per cent, she would save taxes of Rs 15,000 when she invests Rs 50,000 in NPS. Considering the average of 14 per cent returns given by NPS (equity option) in the last five years, the investor would make around Rs 13.23 lakh at the end 25 years. If she invested Rs 15,000 in an equity scheme and make an annual around 12 per cent, she would have created another Rs 2.55 lakh at the end of 25 years. That means the person would have Rs 15.78 lakh at the end of 25 years.
What if an investor decides to give up the tax deduction and invests in a multicap scheme? He would invest Rs 50,000 (would not get the tax break of Rs 15,000), and assuming an average return of 12 per cent, he make around Rs 8.50 lakh at the end of 25 years. If you take 18 per cent returns offered by multicap schemes in the last five years, he would make around Rs 31.33 lakh at the end of 25 years.
As you can see, if the equity is doing very well, giving up taxes and investing in a regular mutual fund scheme can offer better returns. However, one should also consider the withdrawal options before taking a final call.
Moving on to withdrawals, the person invested in NPS would be able to withdraw 40 per cent of the corpus (Rs 5.29 lakh). He need to use 40 per cent of the corpus to buy an annuity. The remaining 20 per cent (Rs 2.64 lakh) can be used to buy an annuity or withdrawn after paying taxes. The multicap investor need not bother about these things, as he is free to use the money as he pleases. He also doesn’t have to pay any tax on returns. Currently, long-term capital gains tax is nil.