Letters to the Editor's Note

Dhirendra Kumar's Editor's Note on NPS (National Pension System) Tier 2 taxation, published on August 24, received significant feedback from readers. The thoughtful responses underscored the importance and relevance of the topic. As a gesture of appreciation, we dedicate this section to our valued readers, whose insights help enrich these discussions.

Summary

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. That statement wasn't entirely accurate. While you can invest and redeem from Tier 2 funds much like you would with mutual funds, the taxation rules differ significantly. Since Tier 2 isn't specifically mentioned in the tax code, it falls under the general category of 'income from other sources.' This income is added to your overall earnings in the year of realisation and is taxed at your marginal rate. Unlike mutual funds, NPS Tier 2 doesn't offer tax advantages. However, it's not as bad as interest income, which is taxed annually. In Tier 2, the money accumulates until you redeem it, which allows for some compounding of gains.

There's a twist, though. NPS allows a one-way switch from Tier 2 to Tier 1, meaning that at retirement, Tier 2 funds can be treated like post-retirement NPS withdrawals. This allows 60 per cent of the withdrawal to be tax-free, with the remaining 40 per cent used for purchasing an annuity, which is taxed as income in subsequent years. Government employees also have the option of using Tier 2 as a tax-saving instrument under Section 80C, but it requires a three-year lock-in, and it's hard to say how many actually use this option.

Rather than seeing Tier 2 as a mutual fund alternative, it's best viewed as an additional contribution towards your pension, with more liquidity than Tier 1. You can let it accumulate and eventually use it to enhance your pension or withdraw as needed. While the returns are taxed, the full liquidity makes it useful.

As most NPS members know or should know, Tier 1 money isn't completely illiquid. Partial withdrawals are permitted for specific purposes such as children's education, weddings, home purchases or medical emergencies. Interestingly, NPS also allows withdrawals for skill development or starting a new venture. I'm not sure how many people use these provisions, but their existence is noteworthy.

The takeaway here is that the National Pension System has grown into a complex structure with many facets which most people aren't fully aware of. Despite this complexity, its basic utility remains valuable for almost everyone.

What our readers say

Read today's newsletter. It is very informative about NPS Tier 2. Thanks for penning and sharing the newsletter - Mayank N Kamdar

Thank you for sharing insights on the NPS Tier 2 account. I was thinking about moving the funds from Tier 2 to Tier 1 account, but there was no clarity on whether there is any
tax liability on the transfer. Even the PoP (intermediary) was not sure. (However) Now I know that I can move the funds to the Tier 1 account anytime - Lalit Tiwari

The write-up about nooks and corners of NPS provides an interesting piece of information. Thanks - Neelam Bhardwaj

A very insightful article. As you say, most of us really might not be knowing this if you didn't point it out. Thank you for sharing - Dr Shreyas Gandhi

Your note on NPS is an eye-opener regarding switching from Tier 2 to Tier 1. Really appreciated - R Ramesh Kumar

Thanks for your perspective related to NPS Tier 2 investments - Soumitra Chakraborty

Your expert advice in financial matters is excellent. I was not aware of these clauses in NPS. Thanks for enlightening the masses - Dr JP Chugh

I have been using NPS since 2016 for the additional Rs 15,000 tax break and started contributing to Tier 2 in 2020. I have added Rs XX lakh to date in Tier 2, thinking of this as a mutual fund alternative, plus liquidity, plus a one-time transfer to Tier 1 upon maturity.

One good part of Tier 2 is that you can allocate 100 per cent into equity, unlike Tier-1, where it is restricted to 75 per cent. Your note on the taxation part applicable to Tier 2 withdrawal is useful, and I will be careful on future additions to Tier 2.

Thanks for writing informative notes on personal finance - Rishabh Agrawal

The note on NPS Tier 2 was interesting. My viewpoint: if liquidity is not a concern, then why bother to open a Tier 2 account and remember to switch at the time of redemption? Simply put the money in the Tier 1 account. In either case, your contributions above Rs 2 lakh will not earn you any rebate. Let me know if you think otherwise - Mayank Gupta

Thanks a lot for the detailed report on NPS. It was thoroughly well written, covering all aspects of NPS. It was crisp and well researched. Looking forward to reading many more perspectives on Saturday. Thanks, Dhiren - Sai Sankar Kunnathukuzhiyil

This article was originally published on September 17, 2024.