Should You Invest in Tier-II NPS?

 You could end up losing a lot if you do not choose your investments wisely. Even a 1 per cent difference in cost can have a big impact on your corpus. Consider this: If you invest Rs 1 lakh in a mutual fund with 1 per cent excess fund management charge, you will end up paying Rs 7 lakh more over 30 years if we assume a rate of return of 12 per cent. This means you should prefer investments where costs - agent commission and different fee/charges - are low. One product that offers both low cost and high returns is the Tier-II account of the National Pension System or NPS.

The account has been outperforming similar schemes of mutual funds, driven mainly by its low-cost structure. For example, the equity fund of the NPS has given 9.59 per cent returns compared to the 5.6 per cent given by index funds over the past one year. Corporate debt and government bond plans of the NPS gave average returns of 12.50 per cent and 14.53 per cent, respectively, during the period; in comparison, gilt funds returned 11.82 per cent and income funds 9.91 per cent.

The difference can be accounted for by the fund management fees - for an average investor, the total cost in the Tier-II NPS account is 0.50-0.55 per cent per annum as against the 0.35-3 per cent charged by mutual funds.

But is it enough to compare just costs and returns? What about taxation? And what about other aspects such as convenience, simplicity and turnaround time?

Here is a guide to help you understand the Tier-II account of NPS.

TAXABILITY

You can withdraw your money just like in bank fixed deposits or FDs. But there is a catch. Unlike the FD, where only the interest is taxed, here the entire amount withdrawn is taxable. Also, unlike debt funds, investments in corporate debt and government plans of the NPS do not enjoy the indexation benefit. It is a big disadvantage and can bring down returns substantially. So, think carefully before considering the Tier-II NPS account as an alternative to fixed deposits and debt funds.

Hemant Contractor, Chairman, Pension Fund Regulatory and Development Authority (PFRDA), says, "There is no tax exemption for the Tier-II account. The entire amount is taxed depending upon the tax status of the person. Debt mutual funds give the benefit of indexation, while gains from equity funds held for more than a year are not taxed."

"We have written to the CBDT (Central Board of Direct Taxes). We have requested for an exemption and that the NPS Tier-II account be treated like a mutual fund. Till it clarifies, the amount withdrawn will be considered taxable income," he says.

All this makes NPS a lot less attractive. Consider this. NPS will yield Rs 3.37 lakh if a person invests Rs 50,000 a year at 15 per cent over five years. If the same person invests in an income fund, he will accumulate Rs 3.17 lakh, assuming 12 per cent returns. However, the NPS advantage fades away if we compare post-tax returns. The amount in hand would be Rs 2.35 lakh (assuming 30 per cent tax bracket) for NPS and Rs 3.15 lakh for the fund. This is because withdrawal from the Tier-II NPS account would be taxed as per the investor's income tax slab, while capital gains from income funds would be taxed at 20 per cent with indexation. So, consider the tax aspects before being bowled over by the low cost of NPS.

Parizad Sirwalla, Director, Tax at B S R & CO (KPMG), says "NPS is not a fund registered under Section 10(23D) of the I-T Act, the equity investment will not be eligible to be [treated] as an equity-oriented fund. Consequently, it may not be eligible for long-term capital gains exemption under Section 10(38) of the Act."

Tax benefits are available only for Tier-I account investments. Here, you can claim a deduction of up to Rs 1.5 lakh under Section 80CCE of the I-T Act. The account is also eligible for an additional tax benefit of Rs 50,000 under Section 80CCD (1B) of the I-T Act.

Sudhir Kaushik, Co-Founder and CFO, TaxSpanner.com, says, "The income tax authority should clarify about the taxability of NPS withdrawals. It is clear that Tier-II withdrawals cannot be taxed like Tier-1 withdrawals as the former investment is not eligible for the Section 80CCD benefit."

Cost Structure

In NPS, you have to pay a fee to each intermediary. For example, you pay account opening and annual maintenance charges to the Central Recordkeeping Agency (CRA) through cancellation of units. You also pay Point of Presence (POP) charges upfront for contribution-related transactions. Apart from these, trustee bank, custodian, NPS Trust and pension fund manager charge by way of adjustment in the net asset value or NAV.

Mutual funds are far simpler - all costs are reflected in NAVs. Manoj Nagpal, Chief Executive Officer, Outlook Asia, says, "NPS and mutual funds use different methods for treatment of costs. In mutual funds, all expenses are reflected in the NAV, whereas in NPS some costs are passed on through the NAV and some through cancellation of units. Thus, NPS has a segregated cost structure where the change in the NAV is not fully reflected in the final return earned by the investor." This can confuse investors.

The second difference is that irrespective of the type of fund (equity or debt or government securities), NPS costs are the same. In case of mutual funds, however, you have to hunt for low-cost funds. In case of income funds, for example, the cost ranges from as low as 0.08 per cent to as high as 3 per cent.

Turnaround Time

In mutual funds, processing of purchases and redemptions is much faster. You get the same day's NAV if the application is submitted by 3 pm. Similarly, in case of redemption, the money is credited on a T + 3 days basis in case of equity funds, and T + 1 day in case of debt and liquid funds.

In NPS, the turnaround time is much more as it is dependent on fund settlement and processing of the transaction by the trustee bank and the CRA.

"The allotment of units and the time taken for redemption do not tightly adhere to turnaround time deadlines. Also, customer service for transaction queries needs to be strengthened. Once the processes move online, these will be taken care of to a large extent," says Nagpal.

"In a mutual fund, the work is done by the fund, which collects contributions and also invests and makes payments. In our case, the PoP collects the money, the CRA maintains records while the fund manager invests. They are different entities. Their charges also differ and cannot be unified as different activities are carried out by different players. Our structure is different from that of mutual funds," says Contractor.

What to do

Till there is clarity on the tax aspect, it is better to stay away from Tier-II NPS accounts. Roopali Prabhu, Head of Investment Products, Sanctum Wealth Management, says, "Research access is better in mutual funds. Moreover, in case of mutual funds, there is better clarity on tax. A wiser choice can give you better returns in mutual fund."