How investing in NPS can help you save tax

Capitalstars Investment Advisor

Although the National Pension System comes with exempt-exempt-exempt (EEE) tax status, there is a catch.

The National Pension System (NPS) is one of the financial products you can use to reduce your tax outgo. You can invest in NPS to save for your retirement as well.

Although the NPS comes with exempt-exempt-exempt (EEE) tax status, there is a catch. If you are planning on investing in NPS to save on tax, here are a few important points you should keep in mind.

The tax-saving benefit under NPS at the time of investing

At the time of investment, the tax-saving benefit of NPS can be claimed under three sections of the Income-tax Act, 1961. These sections are: - (i) Section 80CCD (1), (ii) 80CCD (2), and (iii) 80 CCD (1b).

Section 80CCD (1)

Tax-benefit under section 80CCD (1) is available on an individual's self-contributions to the NPS Tier-I account. Currently, an individual can claim tax benefit on a maximum self contribution of Rs 1.5 lakh in a financial year to the Tier-I account. The amount so deposited up to Rs 1.5 lakh can be claimed as deduction from gross total income before tax, thereby reducing the tax liability.

Therefore, if you have deposited more than Rs 1.5 lakh, say Rs 2 lakh, in your Tier-I NPS account, then you will be able to claim tax benefit on Rs 1.5 lakh only as per income tax laws. Remember, there is no limit on the maximum amount that can be deposited in the Tier-I NPS account.

This deduction comes under the overall limit of section 80C of the Income Tax Act. Current income tax laws allow a maximum deduction of Rs 1.5 lakh on an aggregate basis for the investment and expenditure incurred under sections 80C, 80CCC, and 80CCD (1). Therefore, if you claim deduction of Rs 1.5 lakh under section 80CCD (1), then you cannot claim a deduction of Rs 1.5 lakh under section 80C simultaneously.

Section 80CCD (2)

Tax benefit under 80CCD (2) can be claimed by the individual when the employer deposits the money on behalf of the individual in his/her NPS Tier-I account. According to current income tax laws, the employer can deposit a maximum of 10 percent of the individual's salary. Salary here means basic salary plus dearness allowance. Remember, there is no maximum restriction on how much can be deposited as long as it does not breach the 10 percent limit.

Section 80CCD (1b)

Apart from the above mentioned tax-saving benefits, an individual can claim deduction under 80CCD (1b) for a maximum of Rs 50,000 in a financial year. This additional deduction was introduced in the financial year 2015-16.

For Government employees

From FY 2019-20 onwards, government employees have an option to invest in NPS Tier -II account with a lower lock-in period. A government employee can invest a maximum of Rs 1.5 lakh in the Tier-II account of NPS to claim tax benefit under section 80C. Unlike the lock-in period till the age of retirement, the investment made in the Tier-II account of NPS under section 80C comes with a lock-in period of three years.

Lock-in period of NPS and partial withdrawals

NPS comes with a long lock-in period. The scheme matures once the individual turns 60 years. However, during the duration of the scheme account, partial withdrawal is allowed subject to certain terms and conditions.

For instance, partial withdrawal from NPS is allowed for the higher education of children, the marriage of children, purchase or construction of a residential house or flat, etc., if the Tier-I account has completed three years.

The maximum amount that an individual can withdraw from the Tier-I account is 25 percent of his/her own contribution. Also, according to current income tax laws, a maximum 25 percent withdrawal from subscriber's own contribution will be exempted from tax. Therefore, the maximum amount of partial withdrawal and tax-exempted amounts are equal.

At the time of maturity

As mentioned above, NPS will mature when the individual turns 60 years of age. To make the scheme attractive, in the July 2019 Budget, the government made some changes in the taxation of the scheme at the time of maturity.

Conclusion

Section 80C of the Income Tax Act offers a choice of various specified investment products in which one can invest and save tax. However, while making investments to save tax, one should link their tax-saving investments to their money goals.

NPS comes with a long lock-in period and certain conditions regarding partial withdrawal. In case an urgent monetary need arises, then you might not be able to withdraw from your NPS account except in the specified cases. However, on the other hand, if your goal is saving for retirement, then NPS is one option, apart from EPF that can be looked at.