NPS Tier 1 vs Tier 2 – Which is Better for Your Tax Planning?

In 2004, the Government of India introduced the National Pension System (NPS) as a long-term savings scheme designed to provide individuals with financial security after they retire. Initially, only government employees were allowed to participate in this scheme, but in 2009, it was opened up to all Indian citizens between the age of 18 and 70. 

This means any individual in that age bracket, whether NRI, self-employed, or working in the private sector can invest in NPS. You may have heard people talk about the tax-saving and wealth-building benefits of NPS. But did you know that most of the time, they’re actually referring to the NPS Tier 1 account? Yes! NPS isn’t just one account – it has two types: Tier 1 and Tier 2, and each serves a different purpose.

For many, NPS acts as a valuable tax and investment planning vehicle, and for good reason. Let’s understand why that is as we answer what is tier 1 and tier 2 in NPS and discuss which one might be the right choice for tax planning by looking at the difference between tier 1 and tier 2 NPS accounts.

What is NPS Tier 1 and Tier 2?

Before we compare the two accounts, we’ve got to understand the structure of NPS and how it works as a retirement savings scheme. Regulated by the Pension Fund Regulatory and Development Authority (PFRDA), the NPS allows investors to contribute towards their retirement savings while benefiting from professional fund management. 

As this organisation is established under the Indian Trusts Act, it ensures that the NPS operates with transparency and accountability, and thus it prioritises protecting the investors’ interests.

NPS allows individuals to invest in professionally managed funds consisting of 4 asset classes:

1. Equity (E): This refers to the investments made in the share markets. These instruments provide higher returns with moderate to high risk.
2. Government Securities (G): Includes short and long-term government bonds, state bonds, and other government-backed instruments which provide safety but also lower returns.
3. Corporate Bonds (C): These are also fixed-income instruments, but they offer slightly higher returns than government securities by investing in high-rated corporate debt.
4. Alternative Assets (A): A small portion of investments can be invested in alternative investment funds, real estate investment trusts (REITs), and other alternative investments to diversify the portfolio.

There are two ways in which you can allocate your investments in NPS:

Active Choice: 

This option allows you to manually select the proportion of your contributions across the four asset classes, i.e., Equity (E), Corporate Bonds (C), Government Securities (G), and Alternative Assets (A). By selecting this option you’ll gain the flexibility to build your portfolio based on your risk tolerance and financial goals. However, you should be aware of some allocation limits. 

For example, individuals aged up to 50 years can only allocate a maximum of 75% of their funds to equities. Upon reaching 60, this limit decreases to 50%. If you opt for active choice, you’ll be allowed to change the asset allocation twice a year. You can adjust your portfolio based on market conditions, risk tolerance, financial goals, and circumstances.

Auto Choice: 

As the name suggests, in this option the allocation is done automatically. This allocation is based on the investor’s age. As the investor grows old, the exposure to equities slowly decreases and more funds are shifted into low-risk assets like government securities. If you don’t want the hassle of changing asset allocation from time to time, you can opt for this auto-choice option. Here, investors have three selections to choose from:

• Aggressive life cycle fund, which starts with 75% equity exposure for younger investors and slowly decreases with time. This is because younger individuals can typically take on more risk as they have the time to recover from market fluctuations.
• Moderate life cycle fund, which starts with 50% equity exposure.
• Conservative life cycle fund, which starts with 25% equity exposure.

Now let’s understand what NPS tier 1 and tier 2 accounts are.

NPS Tier 1 Account

The NPS tier 1 account is mandatory. When one begins investing in NPS, this is the default account that they must open to participate in the scheme. To open a Tier 1 account, an investor must make a minimum contribution of Rs. 500 at the time of account opening. After that, one can contribute as much as they wish. Unlike the Provident Fund, there is no maximum investment limit in NPS. You must, however, make a minimum contribution of Rs. 1,000 every year to your Tier 1 account.

Since the main purpose of this account is to help individuals build a retirement corpus, it can only be withdrawn after the investor turns 60. Even then, investors can only withdraw 60% of their funds and must use the remaining 40% to buy an annuity plan, which provides them with a regular pension after retirement.

However, if you have completed at least 3 years in the NPS, you can partially withdraw funds under specific circumstances, like financing your children’s higher education, constructing a house, or covering medical emergencies. You can only withdraw 25% of your contribution amount and only up to three times during your NPS tenure. 

Note that you can only withdraw 25% of your contribution amount, so if you invested Rs. 5 lakh over three years and your investment grew to Rs. 8 lakh, you would still only be eligible to withdraw 25% of your original contribution amount, which is Rs. 1.25 lakh (25% of Rs. 5 lakh), and not 25% of Rs. 8 lakh.

These accounts also offer very attractive tax deductions under Sections 80C, 80CCD(1B), and 80CCD(2) of the Income Tax Act, making it one of the most tax-efficient investment options available.

NPS Tier 2 Account

Moving on to what is tier 2 in NPS. This is an optional account that provides different benefits compared to the Tier 1 account. The NPS tier ii account can be opened with a minimum investment of Rs. 250 and only if you already have an active Tier 1 account. We saw that Tier 1 is more focused on retirement planning. The NPS tier 2 on the other hand is more focused on investment planning as it offers investors much higher liquidity and flexibility. You can withdraw funds from this account anytime as there is no lock-in period involved, and even allocate 100% of your funds to equities under the active choice option.

While the Tier 2 account is attractive from an investment perspective, it does not provide the tax benefits that Tier 1 does. Moreover, no investments in alternative assets are allowed in Tier 2, and funds can only be allocated to equity (E), corporate bonds (C), and government securities (G).

NPS Tier 1 vs Tier 2: Key Differences

Now that you are up to speed with what is tier 1 and tier 2 in NPS, check out how these accounts differ:

The main difference between NPS tier 1 vs tier 2 accounts is their purpose. Since the primary goal of NPS is to help people plan for their post-retirement income, the more popular Tier 1 account is designed with strict withdrawal rules, mandatory annuities, and excellent tax benefits. Tier 2 is an optional investment account that offers better liquidity but limited tax benefits. An investment planner can assess your financial profile and help you determine whether the optional account would be suitable for you.

Tax Benefits of NPS Tier 1

NPS holds the rare status of enjoying the EEE (Exempt Exempt Exempt) tax benefit, a privilege shared by only a few investment options like the Public Provident Fund and Sukanya Samriddhi Yojana.

• The first tax exemption is in the contribution stage. There’s no tax on the principal amount and contributions to NPS tier 1 enjoy deductions under Sections 80C and 80CCD(1B). Combined, these sections allow investors to claim deductions up to Rs. 2 lakh per year, but only under the old tax regime.
• The second exemption is in the accrual stage. As your investment grows, it will attract no tax on returns generated within the NPS Tier 1 account.
• And lastly, the third exemption is in the maturity stage. 60% of the corpus can be withdrawn tax-free, while the remaining 40% must be used to buy an annuity. The regular income from annuity plans is taxable as per the investor’s income slab rate. Even premature withdrawals attract no tax.

Here’s a more detailed look at the NPS tier 1 tax benefit:

Deductions under Section 80C

Every financial year, you can claim a maximum deduction of up to Rs. 1.5 lakh on contributions made towards Section 80C investments like PPF, EPF, ELSS, ULIP, and NPS.

Deductions under Section 80CCD(1B)

This section is an extension of 80C, which allows investors to claim an additional deduction of Rs. 50,000 on contributions made towards NPS. This takes the total tax benefit of NPS to Rs. 2 lakh! Remember that 80C and 80CCD(1B) benefits are only available to investors filing their ITR under the old tax regime.

Deductions under Section 80CCD(2)

If you are a salaried individual and your employer contributes to your NPS Tier 1 account, you can claim a tax deduction over and above the Rs. 1.5 lakh limit under Section 80C and the additional Rs. 50,000 under Section 80CCD(1B). You can claim up to 10% of your basic salary + dearness allowance as a deduction. This benefit is one of the rare tax deductions available even under the new tax regime. You should consider consulting an investment expert if you wish to take advantage of these benefits.

Tax Benefits and Drawbacks of NPS Tier 2

The NPS tier 2 tax benefit is limited compared to Tier 1. Contributions to tier 2 NPS accounts do not qualify for tax deductions under the sections we discussed above. The account lacks the EEE tax status as withdrawals are fully taxable as per your income slab. If you’re thinking about investing through the NPS tier 2 account for the mid to short-term, a meeting with a financial consultant might be helpful. Even though it does not provide tax advantages, the Tier 2 account’s flexible withdrawal rules can be attractive for some investors.

Which Option is Better for Your Tax Planning?

As far as tax planning goes, there’s no doubt which between tier 1 and tier 2 NPS accounts would be the better pick. With multiple tax benefits under Sections 80C, 80CCD(1B), and 80CCD(2), Tier 1 is the superior choice. This account helps investors reduce taxable income while building a retirement corpus. On the other hand, NPS tier 2 offers no major tax advantages. 

Even though it provides greater liquidity and potential for growth due to unlimited equity allocation, it lacks the EEE tax status and makes withdrawals fully taxable. If you want to save more of your hard-earned money, give our expert tax advisory services a try. Our advisors can help you structure your investments through personalised planning, making sure you maximise tax benefits while aligning them with your long-term financial goals.

Conclusion

The NPS tier 1 and tier 2 accounts differ mainly in their purpose, tax benefits, and withdrawal rules. The Tier 1 account is designed for retirement savings and offers many benefits under the Income Tax Act. Since the Tier 2 account focuses mainly on investments, it provides high liquidity but lacks any notable tax advantages.