Nooks and corners of the NPS

A couple of weeks ago, in a column on mutual fund taxation, I mentioned that NPS Tier 2 could be treated like a low-cost mutual fund. What I wrote was not accurate. While you can make investments and redemptions from tier 2 funds just like mutual funds, they are not taxed like mutual funds. Tier 2 has no specific mention in the tax code; therefore, by default, they fall under the general category of 'income from other sources'. This is added to your income in the year it is realised and, therefore, taxed at your marginal rate. Thus, they do not have the tax advantages that mutual funds have. Of course, this is not as bad as interest income, which is taxed as you receive it. In Tier 2, the money accumulates as long as you do not redeem it; thus, it plays a role in compounding the gains.

Suggested read: Does NPS make sense as a tax-saving investment?

There's one twist to this. An interesting thing about NPS is that a one-way switch is available from Tier 2 to Tier 1. Thus, at retirement (or whenever you exit from NPS till age 70), the money accumulated in Tier 2 can be treated the same way as post-retirement NPS withdrawals. This means that 60 per cent of the withdrawal is tax-free. So, if you use 60 per cent of the NPS corpus for lump sum withdrawal and the remaining 40 per cent for annuity purchases, you do not pay any tax then. Only the annuity income you receive in the subsequent years will be subject to income tax at your slab rate. For government employees, Tier 2 is available as one of the permissible 80C tax-saving options with a three-year lock-in. However, it's hard to see if anyone would use it.

This means that Tier 2, instead of being considered a mutual fund alternative, is best considered an extra contribution towards your pension, albeit with better liquidity than your normal Tier 1 NPS assets. You can let it accumulate and eventually use it to enhance your pension. I'm not sure how many people have done this till now, but the design of the asset class is best suited for use in this manner. Or, if you need the money at some point, you can withdraw whatever you need. Of course, the returns on the withdrawn amount will be income, but at least full liquidity is available regardless of what you want the money for.

As most NPS members know-or should know-Tier 1 money is not completely illiquid and also available for withdrawal, but only partially and for specific purposes. You can withdraw partially if you need funds for your children's higher education or to finance their wedding expenses. Additionally, you can tap into your NPS funds if you plan to purchase a home or construct a residential property. The system also recognises health-related emergencies, allowing withdrawals to treat specified illnesses. In cases where the account holder experiences a disability of more than 75 per cent, partial withdrawals are permitted. These are what one would expect. However, there are two more circumstances in which withdrawals are permitted, which don't quite fit the pattern. One is "Skill development/re-skilling or any other self-development activities", and the other is "Establishment of own venture or any start-ups". Again, I don't know whether anyone uses these provisions, but that they exist is interesting and useful.

Suggested read: (Maybe) another upgrade for NPS

The eventual moral of the story (including for me) is that the National Pension System is now a large and complex beast with many nooks and corners that few people are familiar with. I guess that's the fate of most such systems, and none of these detract from their basic utility for almost everyone.

Also read: Getting started with NPS