NPS vs mutual funds: The better choice to set up your retirement corpus

You cannot exit before age 60 but that is not necessarily a disadvantage

The National Pension System (NPS) and mutual funds are similar somewhat: Both are market-linked products managed by professionals.

Which is a better vehicle to accumulate your retirement corpus: NPS or mutual funds?

With NPS, you can split your money across equity funds (E), government bonds (G) and corporate bonds (C). There is asset class A, too, where you get exposure to alternative assets like REITs, INVITs and AIFs.

You can select ‘active choice’, where you decide the allocation to various asset classes or funds (E, C, G, A). Maximum equity allocation can be 75 per cent and that for A can be 5 per cent.

Or, you can choose from three lifecycle funds (aggressive, moderate, conservative). In these funds, the allocation to E, C, and G funds is pre-defined as per a matrix and the risk in the portfolio (exposure to E) goes down with age. Portfolio rebalancing happens automatically.

Mutual funds are of several types: Equity, debt funds, gold, silver, and even foreign equities.

NPS, mutual fund exit rules

In NPS, you cannot exit before age 60 and your money would be locked until then. Rules allow you to defer exit until the age of 75. At the time of exit, you can withdraw up to 60 per cent of the accumulated corpus as a lump sum. You must utilise the remaining 40 per cent to purchase an annuity plan. You can even utilise the entire amount to purchase an annuity plan.

You can exit NPS prematurely too once you complete 10 years. However, for pre-mature exit, you must use 80 per cent of the accumulated corpus to purchase an annuity plan. Only 20 per cent can be taken out as a lump sum.

In mutual funds, there is no restriction on exit and you can sell whenever you want. The only exception is ELSS where your investment is locked in for three years from the date of investment.

In case of NPS, annuity purchase will happen with pre-tax money. You can purchase annuity plans using your mutual fund proceeds. However, annuity purchase will happen with post-tax money and selling a mutual fund will result in capital gains liability.

Tax on NPS, mutual fund investments

Own contribution to NPS account: If you are filing Income Tax Return (ITR) under the old tax regime, you will get benefit under Section 80CCD (1B) for up to Rs 50,000 per financial year for investment in Tier-1 NPS. This tax benefit is available over and above tax benefit of Rs 1.5 lakh under Section 80C.

Benefit under Section 80CCD (1B) is not available under the new tax regime.

Employer contribution: This is applicable to only salaried employees who can save tax if their employer offers to contribute to NPS account.

Employer contribution to NPS, Employees Provident Fund and superannuation accounts is exempt from tax up to Rs 7.5 lakh per annum. For NPS, this tax exemption has an additional cap. Such a contribution must not exceed 10 per cent of basic salary. The cap increases to 14 per cent for state and central Government employees.

In case of mutual funds, there is no tax benefit on investment, except for ELSS. Investment in ELSS qualifies for tax benefit under Section 80C of the Income Tax Act.

Tax treatment on exit

NPS: On exit, any lump sum withdrawal (up to 60 per cent of the accumulated corpus) is exempt from income tax.

The remaining amount must be used to purchase an annuity plan. While this amount is not taxed, the payout from an annuity plan is added to your income and taxed at your slab rate.

Mutual fund taxation depends on the type of mutual fund and the underlying domestic equity exposure.

Early retirement in NPS, mutual funds

What if you want to retire at age 55? NPS is rigid: Retirement means 60 and above. If you exit at the age of 55, then you must use 80 per cent of the accumulated corpus for purchasing an annuity plan.

You can continue a NPS account after retirement. Hence, even if you were to retire at 55, you can continue and even contribute to your NPS account until the age of 60, 70, or 75.

In NPS, your investments do not have to be systematic. You can even make big lump sum investments. No limits. With other pension products, you must pay a certain amount of premium every year. Topping up is not easy.

Proceeds from ULIPs (with annual premium of more than Rs 2.5 lakh) and traditional plans (with annual premium of more than Rs 5 lakh) are taxable. There is no such problem with NPS: You can withdraw 60 per cent of accumulated corpus without being taxed. In pension plans of insurance companies, you can withdraw only one-third of the accumulated corpus tax free.

NPS, mutual fund costs

NPS is the cheapest investment product: the management fee is less than 10 basis points.

Mutual funds expenses are much higher. Depends on multiple factors. Regular or Direct. Equity or Debt. Active or Passive.

With an annuity plan, you pay a lump sum to the insurance company which guarantees you an income stream for life.

Mandatory annuity purchase is said to be a problem with NPS but I do not see it that way. Any good retirement product should have the facility to divert an allocation towards annuity purchase. However, you must buy the right variant at the right age.

With annuity plans, you can lock in an interest rate for life – no other product can do this. There are long-term government bonds with maturity of up to 40 years but not for life.

Staggered annuity purchases can increase income and reduce risk in the portfolio. By ensuring a basic level of income, you can take higher risk (commensurate with your risk profile) with your remaining investments and potentially earn better returns.

The writer is a Sebi registered investment advisor.