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NPS Tier 1 vs. Tier 2: An Overview of Tax Benefits

Updated: Jun 7


NPS Tier 1 vs. Tier 2

Indians have always talked about financial preparation. Retirement planning is the most important component of financial planning, particularly for those who are employed. Paychecks cease pouring in after retirement, but bills don't. Retirement planning might become challenging if you don't start early. Investing in different retirement savings plans is an option. The National Pension System is one such advantageous programme. In 2004, the government introduced NPS. You can read about the distinctions between NPS Tiers 1 and 2, as well as the tax advantages, in this comprehensive guide.

 

Table of Contents

 

Understanding NPS

One of the better retirement options offered by the Indian government is the National Pension Scheme or NPS. Although NPS is mostly used for retirement savings, you can also invest in it for short-term objectives and growth. The National Pension System (NPS) is a government-sponsored pension plan that was introduced in 2004. In 2009, the government opened it up to the public, even though it was previously only available to government employees. While still employed, people can make contributions to their NPS accounts, and after they age 60, they can take them out. NPS is essentially an annuity product meant to serve as a retirement fund when an individual leaves employment. NPS offers two types of accounts, listed as follows:

  • Tier 1 Account: Intended for retirement savings for Indian nationals as well as workers in the public and commercial sectors.

  • Tier 2 Account: Intended for general investments.


Tier 1 NPS Account

A Tier 1 account is designed primarily for retirement. It does, nevertheless, permit partial withdrawals for significant life events. Furthermore, the account provides investors with the most possible tax savings. Once an Indian citizen becomes eighteen, they can open an account with this company. The age limit to open an NPS Tier-1 account is 60. Investment options have no upper limit, but tax advantages are only available to a certain extent depending on your income. At least Rs. 500 must be contributed to a Tier-1 account per transaction, and Rs. 6000 must be contributed annually. Furthermore, you must make an investment at least once every fiscal year.

Upon retirement, resignation, or in the event of your death, your family members may take money from your Tier-1 NPS account. However, if you leave your job before turning 60, you can only take out up to 20% of the corpus as a lump payment; the remaining amount should be placed into an instant annuity account to get a pension. You may also partially step back before reaching adulthood or quitting. 


Tier 2 NPS Account

Except for tax savings and lock-in barriers, the Tier 2 NPS account is open-access and offers all the investing benefits of the Tier 1 account. The Tier 2 NPS account's sole restriction is the required minimum annual investment. To initiate the account, a minimum contribution of Rs. 1000 is required. An annual minimum contribution of Rs. 250 is needed. After a fiscal year, the minimum amount in an account should be Rs. 2000. 

The amount you can save, take out of the account, and when you can do so are both unlimited. But there are also no tax advantages. The profits on your assets are added to your taxable income for the year upon withdrawal and subject to slab rates of taxation.


NPS Tier 1 vs. NPS Tier 2

Table of NPS Tier 1 vs. NPS Tier 2

NPS Tier 1 and NPS Tier 2 Returns: Tax Benefits

When investing, you should be aware of the following NPS tier 1 and tier 2 tax benefits: 

  • All NPS Tier 1 subscribers are eligible for a deduction of up to Rs. 1.5 lakhs under Section 80CCE.

  • If you buy an annuity, the full money invested is tax-free. But the income of the annuity will be subject to the applicable rates of taxation. 

  • Up to 40% of a lump sum payout received after reaching 60 is tax-free. You must purchase an annuity with taxable returns using the remaining funds.

  • If a partial withdrawal is made, 25% of the amount removed is tax-free.

  • Tier 1 investors are eligible for an additional deduction of up to Rs. 50,000 under Section 80CCD(1B). Recall that this discount exceeds the Rs. 1.5 lakh deduction allowed under the Income Tax Act of 1961, 80CCD (1).

Take these factors into account when filing your ITR to ensure significant tax savings. These benefits are only available to owners of Tier 1 NPS accounts, though. 


Similarities Between NPS Tier 1 and NPS Tier 2

  • Government-Sponsored Pension programmes: In India, the government sponsors the NPS Tier 1 and Tier 2 pension programmes. 

  • Voluntary Contributions: You can contribute voluntarily to your retirement savings at either tier. 

  • Withdrawal Restrictions: There are limitations on early withdrawals for both tiers, along with particular requirements for accessing money prior to retirement. 

  • Professional Fund Management: With investment alternatives including government securities, corporate bonds, and stock, both categories include professional fund management. 

  • Permanent Retirement Account Number (PRAN): For both Tier 1 and Tier 2 accounts, you are assigned a Permanent Retirement Account Number (PRAN) that does not change.

  • Pension Annuity: With either tier, you have the choice to use your corpus accumulation to buy a pension annuity when you're retired. 

  • Portability: You can move your accounts between industries and regions with either of the NPS tiers.


Choosing Between NPS Tier 1 and NPS Tier 2

  • Tier 1 investors may be eligible for a tax exemption for an extra investment of up to Rs. 50,000 under Section 80CCD (1). Both the purchase of annuities and premature withdrawals are deductible. 

  • Tier 2 accounts do not enjoy tax benefits. This severely limits your potential to lower your annual taxes. 

  • Because Tier 1 accounts are much more restricted, there are fewer alternatives for withdrawals before maturity. 

  • Subscribers on Tier 2 can take early withdrawals to pay for certain bills. Thus, with the money raised, Tier 2 customers will be able to better handle all of their financial needs. 


Conclusion

Depending on personal needs and financial goals, NPS Tier 1 and Tier 2 accounts can be chosen. Tier 1 is intended for long-term retirement planning and has tax-beneficial withdrawal limitations. Conversely, Tier 2 offers unrestricted withdrawals and greater flexibility for short-term financial goals, but it does not offer the same tax benefits. The best NPS account type for your financial plan should be chosen after carefully considering your goals and risk tolerance.


FAQ

Q1. What happens to NPS Tier 1 if the investor expires before the age of 60?

The nominee or the subscriber's legal heir will receive the whole NPS corpus if the subscriber passes away before turning 60.


Q2. What is the tax benefit of investing in a Tier 1 NPS account?

You are eligible to deduct Rs. 1.5 lakhs under section 80CCD(1) and an additional Rs. 50,000 under section 80 CCD(1B) of the Income Tax regulations. 


Q3. Is the income from the annuity purchased with the Tier 1 corpus taxable?

No, there is no tax on the income from the annuity that was bought with the Tier 1 corpus.


Q4. How is the NPS return rate determined?

The performance of the underlying investments largely determines the returns of the National Pension System (NPS), a market-linked retirement savings plan. The following variables are used to determine the return rate for each NPS scheme: 

  • Allocation of assets

  • Market performance 

  • Returns reinvested

  • Charges and outlays 


Q5. Is there any option for withdrawal from the Tier 1 NPS account?

Yes, there are clauses that allow withdrawals from the Tier 1 NPS account in particular situations.

Partial Withdrawals:

  • Following three years of account opening

  • Particular financial exigencies, including sickness, medical costs, or home acquisition 

Complete Withdrawals

  • 60 years of age attained

  • Early departure is subject to fines and limitations. 


Q6. Can you explain the taxation aspects associated with withdrawals from NPS Tier 1 and Tier 2 accounts, considering factors like lock-in periods and eligibility criteria?

Taxation on withdrawals from NPS Tier 1 and Tier 2 accounts varies based on factors such as lock-in periods and eligibility criteria. Withdrawals from Tier 1 are subject to certain conditions and tax implications, with partial withdrawals allowed only under specific circumstances like retirement or partial withdrawal for specific purposes. On the other hand, withdrawals from Tier 2 are taxed according to the individual's income tax slab, similar to other investments like mutual funds, with no lock-in period.


Q7. Is NPS Tier 1 tax-free?

NPS Tier 1 is tax-free. The precise tax advantages of NPS Tier 1 are as follows: 

  • Contribution tax deduction: Under Section 80C of the Income Tax Act, you are eligible to deduct up to Rs. 1.5 lakhs from your taxable income. 

  • Rs. 50,000 additional tax deduction: Section 80CCD(1B) of the Income Tax Act permits you to deduct an additional Rs. 50,000 in taxes. 

  • Tax-free returns: At the moment of withdrawal, all returns from your NPS Tier 1 account are free of taxes.


Q8. Is NPS Tier 2 taxable?

Under the Income Tax Act, donations made to the NPS Tier 2 account are not deductible from taxes. However, if the Tier 2 account is kept for longer than 36 months, withdrawals are subject to a flat 20% tax rate upon indexation.


Q9. How does the liquidity differ between NPS Tier 1 and Tier 2 accounts, and how does this impact investment strategies for long-term financial planning?

The liquidity differs significantly between NPS Tier 1 and Tier 2 accounts. Tier 1 comes with restrictions on withdrawals and has a lock-in period until retirement, while Tier 2 offers more liquidity, allowing for anytime withdrawals.


 This impacts investment strategies, as Tier 1 is more suited for long-term retirement planning due to its lock-in feature, whereas Tier 2 can be utilized for short to medium-term goals where liquidity is a priority.


Q10. In what scenarios would individuals opt for NPS Tier 2 over Tier 1, considering factors such as flexibility, investment options, and overall portfolio diversification?

Individuals might opt for NPS Tier 2 over Tier 1 when flexibility and liquidity are paramount. Tier 2 offers more flexibility in terms of withdrawals, allowing investors to access their funds anytime without any penalty. 


Additionally, Tier 2 provides a wider range of investment options, including equity, corporate bonds, and government securities, enhancing portfolio diversification compared to Tier 1's predominantly debt-oriented investments.


Q11. Are there any specific regulatory changes or updates that distinguish the treatment of NPS Tier 1 and Tier 2 accounts, particularly in terms of eligibility criteria, contribution limits, or withdrawal norms?

Regulatory changes may impact the treatment of NPS Tier 1 and Tier 2 accounts, affecting aspects such as eligibility criteria, contribution limits, and withdrawal norms. 


These changes could include adjustments in contribution limits, relaxation of withdrawal restrictions, or amendments in eligibility criteria based on evolving regulatory guidelines or government policies aimed at enhancing the attractiveness and accessibility of NPS accounts for investors.


Q12. Which is the better option for me: NPS Tier 1 or Tier 2?

If you want to take advantage of tax benefits and are primarily focused on saving for retirement, NPS Tier 1 is a better option. For people who need flexibility in their investments and might need access to money before they reach retirement age, NPS Tier 2 is a better option.


Q13. Can I transfer my funds from Tier 1 to Tier 2?

It is not possible to move funds from Tier 1 to Tier 2. Fund transfers are only permitted from Tier 2 to Tier 1, not the other way around.



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