If you work in the private sector, you typically contribute to your provident fund (PF) as part of your retirement savings. You can also invest in national pension system (NPS) and contribute to your Tier 1 and Tier 2 accounts. In this article, we discuss factors that you must consider before investing in NPS.

The trade-off

The significant benefit of investing in NPS is the tax savings. NPS is eligible under the Exempt Exempt Exempt (EEE) category along with PF and PPF.

This means your returns in Tier 1 NPS account will be tax-exempt during the life of the investment and at the time of maturity.

In addition, your annual NPS investment is eligible for tax deduction under Section 80C of the Income-Tax Act up to a maximum of 1.5 lakh. You can get an additional benefit up to 50,000 under Section 80CCD (1B) for your investment in the Tier 1 account.

Note that the deduction relating to your NPS contribution based on your base salary and dearness allowance under Section 80CCD (1) comes within the 1.5 lakh limit. Also, claiming tax deduction for your employer contribution will only neutralise the tax effect because your employer’s contribution is first added to your total salary.

What about the risks associated with NPS investment? One, NPS locks your investment till age 60, although premature withdrawal is possible with some restrictions. Now, the primary source of returns on NPS is capital appreciation. A capital appreciation product with a lock-in feature is exposed to high asymmetric returns effect (ARE) — the risk that unrealised gains can be wiped out easily and unrealised losses can be difficult to recover when markets decline.

Two, 40% of the portfolio value at age 60 must be used to buy an annuity. While annuities moderate longevity risk, they are typically low-yield retirement products that most individuals do not prefer.

And three, there is regulatory risk — that additional tax benefit (50,000) can be withdrawn in the future. So, is the additional tax deduction that is currently available a good trade-off for the associated risks?


You could consider investment in Tier 1 NPS because the additional tax benefit of 50,000, till it is applicable, saves 15,000 annually (30% tax rate). This savings adds to your investment return.

That said, be mindful of keeping your NPS investments to less than 20% of your total portfolio value to manage the ARE associated with the investment.

(The author offers training programmes for individuals to manage their personal investments)