How tax saving via NPS may help you collect higher annuities in retirement

Key Highlights

• NPS gives income tax deduction benefit up to Rs 2 lakh
• At retirement one has to invest 40% of the fund to buy an annuity
• Rates of most of annuities are hovering around a measly 6%
• Many other investment options may offer more than 7%
• The tax saving through NPS for people in higher tax slab is substantial
• It helps people save more and build bigger corpus over the years
• A bigger corpus enables a higher lumpsum and higher annuity even at lower rate
• NPS could be one of the preferred retirement planning options among many others

National Payment System (NPS) has become a popular savings instrument not only for retirement but also for tax saving. Besides Rs 1.5 lakh annual deduction under usual 80CCD, it offers additional deduction of Rs 50,000 under section 80CCD(1B). With total deduction of Rs 2 lakh you can effectively save income tax of around Rs 60,000 in a year if you fall in the high-income tax bracket of 30 per cent.

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On top of it, most of the NPS funds have delivered attractive return without taking higher risk. As on November 20, 2020, the seven-year annualised return of five out of six equity funds with track record of seven years is above 11 per cent, while the sixth fund also delivered decent return of 10.17 per cent.

Moreover, all six corporate bond funds of NPS have given an annualised return of 10 per cent in last seven years. The government security funds did not disappoint either as all six have delivered an annualised return above 11 per cent in last seven years. Besides, when it comes to the cost of managing funds, NPS is quite competitive.  

"There are advantages on the NPS in the form of tax benefits when the investment is made, as well as lower costs of the NPS vis-a-vis most other investment options at this point," says Vishal Dhawan, founder, Plan Ahead Wealth Advisors. It is this performance which is making NPS a preferred investment vehicle.

The only limitation, however, is that you cannot take out all your savings and return as NPS subscriber can withdraw only 60 per cent of the accumulated corpus while it is mandatory for them to buy annuity with the remaining 40 per cent.

Most of the annuities are currently giving less than 6 per cent when you go for the option of return of purchase price while you may get a return of around 7 per cent on PMVVY, SCSS, RBI Bond and some FDs held in small finance banks. So, does it make sense to divert larger sum toward NPS for retirement savings and get tax deduction benefit?

While conservative investors may not mind slightly lower returns on annuities as it comes with a guarantee, savvy investors may prefer generating higher income even if it involves some risk. Should such savvy investors invest in NPS that gives tax-free return but mandates 40 per cent annuity purchase which in turn gives low returns?

The more tax you save, the higher will be your savings, even higher if you are in higher tax brackets. This will enhance your contribution to the retirement fund. If you keep saving 30 per cent tax and channelise this saving towards NPS it would effectively mean that your corpus would grow by at least 40 per cent.

Assume that you create a retirement corpus of Rs 1 crore through an investment instrument without tax saving. If you move to NPS, you may make additional investment with your tax savings of 30 per cent, and by doing so you can create a corpus of more than Rs 1.4 crore. As you receive 60 per cent as lump sum at the vesting age, thanks to additional saving you will receive a lumpsum of Rs 84 lakh (60 per cent of Rs 1.4 crore) instead of Rs 60 lakh (60 per cent of Rs 1 crore).

Moreover, you will not suffer any loss on account of lower annuity rates because you will have high amount for annuity investment. As against Rs 40 lakh in free-to-invest option, you will have Rs 56 lakh in NPS by investing additional tax saving.

If the annuity rate offered is 6 per cent on Rs 56 lakh and you compare it with higher rate of 7.5 per cent on free-to-invest option of Rs 40 lakh you will get a higher monthly income of Rs 28,000 in NPS instead of Rs 25,000 in free investment option.

It means the tax saving that you do over a period of time can effectively give you higher return than what you lose out in terms of lower annuity rate. Besides, your returns in annuities are safer and guaranteed compared to other options.

As one needs to have a good portfolio of debt, equity, gold and real estate while saving for major life goals like retirement, even savvy investors who can depend heavily on equities directly or through MFs can invest in NPS as part of a conservative investment option.

"The annuity at maturity may not be the only variable to base this decision on. We continue to believe that the NPS is a good option for investors irrespective of sophistication," says Dhawan of Plan Ahead Wealth Advisors.

While there is no denying that you can use many other investment products for retirement planning, NPS could be one of the preferred options. "For retirement income, other options can be used along with NPS annuity as it is a great vehicle to accumulate a good corpus for retirement in the first place," says Suresh Sadagopan, Founder, Ladder7 Financial Advisories.

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