 "Taxation not a deal breaker for young NPS investors")
Saving for retirement is one of the most important financial goals for an individual. A back-up plan may be possible for all other financial goals, not retirement.
The Employees' Provident Fund (EPF) has been the default tool for salaried individuals to save for retirement. There are over 150 million provident fund accounts with the Employees' Provident Fund Organisation (EPFO), which manages over Rs 6.5 lakh crore of your money. Both the employee and the employer contribute 12 per cent each in the fund, which earns a tax-free fixed return announced every year. Part of the employer's contribution also goes to the Employees Pension Scheme. The EPF is exempt-exempt-exempt, meaning the contributions get a tax-break, and the accumulated returns as well as withdrawals are tax-free.
New PF norms
The EPF is now set for a change. First, as per the Budget announcement earlier this year, you will get an option to decide whether your PF contributions go to the EPFO or the National Pension System (NPS). This will come into effect after the necessary amendments are done to EPF & MP Act, 1952. Second, the EPFO can now invest a minimum of 5 per cent of its corpus into equities, up to a maximum of 15 per cent. This changes the fundamental character of the EPFO from one offering fixed returns by investing in purely debt instruments to one offering variable returns from a mix of debt and equity investments.
Despite the advantages, maximising contributions to both the EPF and NPS may not be possible for everyone as these contributions can impact savings or immediate cash-flows. Most of us may still have to choose one of the two.
NPS or EPF?
The choice depends on three key questions. The most important question is that of liquidity. Under EPF, you can withdraw the entire corpus and use it as you like. This is one of the biggest benefits and yet is one of the biggest banes of retirement savings in India. Most people withdraw their provident funds much ahead of time - either while changing jobs or by using the withdrawal provisions provided by the EPFO - and are left with a very small corpus at the end of their working years. Indeed, one could argue, that the EPF has not served its purpose of being an effective pension tool for the vast population. It is here that the NPS scores over EPF by mandating a 40 per cent annuitisation and limited liquidity, thus ensuring that the role of creating a pension kitty is achieved.
The second question is that of tax treatment. The contributions in both the EPF and NPS are tax deductible but the NPS allows for an additional deduction of Rs 50,000, which is over and above the Rs 1.5 lakh deduction under section 80C. The bigger difference in taxation comes at the time of withdrawals. The entire EPF corpus is tax-free during withdrawal (subject to five years of continuous service). In the case of NPS, however, the withdrawals are taxable under exempt-exempt-tax (EET).
This need not be a deal breaker for all. The tax difference between EPF and NPS can be nullified if the incremental returns from the NPS is 33 divided by the investment tenure. A 25-year-old with 35 years to go for retirement, will need to generate an additional 0.95 per cent return annually to nullify the tax difference. This is achievable and so the EET treatment need not be a real deal breaker in this case. However, if you are already 50 years old and are now planning to shift to the NPS, the latter will have to generate incremental returns of 3.3 per cent to nullify the tax difference. This person may be better off not making the shift.
Lastly, you need to address the question of asset allocation. Although the EPF will now invest 5 per cent in equities, this is not on individual accounts and only on incremental flows. The overall impact on the entire corpus will be limited to 1-1.5 per cent in the initial 3-4 years, and it may take a decade for the overall corpus to reach a 5 per cent equity exposure. So, there may not be any significant impact on the EPF returns at least in the next decade, and those retiring in the near-term may not see any material impact of this exposure.
In contrast, the NPS allows you to choose your asset allocation. This flexibility of choosing your own asset allocation is one of the key benefits of NPS, and can make a significant impact on your retirement corpus. Unfortunately, most people do not realise its importance.
The Employees' Provident Fund (EPF) has been the default tool for salaried individuals to save for retirement. There are over 150 million provident fund accounts with the Employees' Provident Fund Organisation (EPFO), which manages over Rs 6.5 lakh crore of your money. Both the employee and the employer contribute 12 per cent each in the fund, which earns a tax-free fixed return announced every year. Part of the employer's contribution also goes to the Employees Pension Scheme. The EPF is exempt-exempt-exempt, meaning the contributions get a tax-break, and the accumulated returns as well as withdrawals are tax-free.
New PF norms
The EPF is now set for a change. First, as per the Budget announcement earlier this year, you will get an option to decide whether your PF contributions go to the EPFO or the National Pension System (NPS). This will come into effect after the necessary amendments are done to EPF & MP Act, 1952. Second, the EPFO can now invest a minimum of 5 per cent of its corpus into equities, up to a maximum of 15 per cent. This changes the fundamental character of the EPFO from one offering fixed returns by investing in purely debt instruments to one offering variable returns from a mix of debt and equity investments.
Despite the advantages, maximising contributions to both the EPF and NPS may not be possible for everyone as these contributions can impact savings or immediate cash-flows. Most of us may still have to choose one of the two.
NPS or EPF?
The choice depends on three key questions. The most important question is that of liquidity. Under EPF, you can withdraw the entire corpus and use it as you like. This is one of the biggest benefits and yet is one of the biggest banes of retirement savings in India. Most people withdraw their provident funds much ahead of time - either while changing jobs or by using the withdrawal provisions provided by the EPFO - and are left with a very small corpus at the end of their working years. Indeed, one could argue, that the EPF has not served its purpose of being an effective pension tool for the vast population. It is here that the NPS scores over EPF by mandating a 40 per cent annuitisation and limited liquidity, thus ensuring that the role of creating a pension kitty is achieved.
The second question is that of tax treatment. The contributions in both the EPF and NPS are tax deductible but the NPS allows for an additional deduction of Rs 50,000, which is over and above the Rs 1.5 lakh deduction under section 80C. The bigger difference in taxation comes at the time of withdrawals. The entire EPF corpus is tax-free during withdrawal (subject to five years of continuous service). In the case of NPS, however, the withdrawals are taxable under exempt-exempt-tax (EET).
This need not be a deal breaker for all. The tax difference between EPF and NPS can be nullified if the incremental returns from the NPS is 33 divided by the investment tenure. A 25-year-old with 35 years to go for retirement, will need to generate an additional 0.95 per cent return annually to nullify the tax difference. This is achievable and so the EET treatment need not be a real deal breaker in this case. However, if you are already 50 years old and are now planning to shift to the NPS, the latter will have to generate incremental returns of 3.3 per cent to nullify the tax difference. This person may be better off not making the shift.
Lastly, you need to address the question of asset allocation. Although the EPF will now invest 5 per cent in equities, this is not on individual accounts and only on incremental flows. The overall impact on the entire corpus will be limited to 1-1.5 per cent in the initial 3-4 years, and it may take a decade for the overall corpus to reach a 5 per cent equity exposure. So, there may not be any significant impact on the EPF returns at least in the next decade, and those retiring in the near-term may not see any material impact of this exposure.
In contrast, the NPS allows you to choose your asset allocation. This flexibility of choosing your own asset allocation is one of the key benefits of NPS, and can make a significant impact on your retirement corpus. Unfortunately, most people do not realise its importance.
The writer is CEO, Outlook Asia Capital