What is National Pension System (NPS) and How it Works?

The National Pension System (NPS) is a government-backed retirement savings scheme designed to provide financial security to Indian citizens in their golden years. Launched in 2004 and extended to all citizens in 2009, NPS offers a flexible, low-cost, and tax-efficient way to build a retirement corpus.

As of March 2023, the NPS had over 6.2 crore subscribers, reflecting its growing acceptance among salaried professionals, self-employed individuals, and corporate employees. Managed by trusted Pension Fund Managers (PFMs), the system operates under the regulatory oversight of the Pension Fund Regulatory and Development Authority (PFRDA), ensuring transparency and security.

How Does NPS Work?

You can subscribe to NPS online or offline (we have explained the enrolment process in detail – keep reading). Upon subscribing, you can regularly contribute to your NPS account. Upon retirement, 60% of the invested amount can be withdrawn in lump sum. The remaining 40% is used for purchasing an annuity from a life insurance company. This helps you create an income stream where you regularly earn a pension. Here’s how NPS investment works:

1. Active Choice

• You have complete control over how their contributions are distributed across the four asset classes.
• Custom Allocation: Decide the percentage of funds to allocate to each class (subject to age-based caps for equity).
• Flexibility: Ideal for individuals who are knowledgeable about markets or have specific financial goals.

2. Auto Choice

• A pre-defined, age-based investment strategy designed for subscribers who prefer a hands-off approach.
• Life Cycle Funds: Automatically adjusts the allocation between equity, corporate bonds, and government securities based on the subscriber’s age.
• Aggressive Life Cycle Fund (LC75): Starts with 75% equity, gradually reduces to 15% by age 60.
• Moderate Life Cycle Fund (LC50): Starts with 50% equity, reducing to 10% by age 60.
• Conservative Life Cycle Fund (LC25): Starts with 25% equity, reducing to 5% by age 60.

3. Pension Fund Managers (PFMs)

• Role: NPS investments are managed by Pension Fund Managers (PFMs) authorized by the Pension Fund Regulatory and Development Authority (PFRDA).
• Subscriber Choice: You have the flexibility to choose your preferred PFM from the list provided by PFRDA. 
• Performance Transparency: PFRDA publishes fund performance data, enabling subscribers to compare and switch PFMs if desired.

4. Contribution and Investment Process

Step 1: Contributions

• Subscribers make contributions through POPs (Point of Presence - offline) or the eNPS portal (online).
• Minimum annual contributions: ₹500 to open an account and minimum contribution of ₹1,000 annually for Tier-I and ₹1,000 contribution to open an account – with no mandatory annual contribution for Tier-II accounts.

Step 2: Allocation of Funds

• Contributions are distributed among asset classes based on the subscriber’s chosen strategy (Active or Auto Choice).

Step 3: Investment by PFMs

• The PFMs invest contributions in market instruments according to the allocation strategy.

Step 4: Monitoring and Adjustments

• Subscribers can monitor their investments via regular statements.
• Changes in allocation, fund managers, or strategies are allowed annually.

5. Market-Linked Returns

NPS returns are not fixed, as they depend on market performance. However, historical data suggests:

• Equity Funds: Deliver the highest returns, around 10-12% annually.
• Corporate Bonds: Moderate returns of 7-9% annually.
• Government Securities: Stable returns of 6-8% annually.

6. Risk Management

NPS manages risk through:

• Diversification: Investments are spread across multiple asset classes, reducing the impact of poor performance in one class.
• Age-Based Allocation: Auto Choice reduces equity exposure as the subscriber ages, minimizing risk closer to retirement.
• Cap on Equity Exposure: Equity allocation is capped at 75%, reducing potential volatility.

Types of NPS Accounts

There are two types of NPS Accounts – Tier 1 and Tier 2.

1. NPS Tier 1 Account

The NPS Tier-1 account is a government-supported long-term investment plan designed to provide a steady income post-retirement. Contributions to this account remain locked until the subscriber turns 60, although partial withdrawals are permitted under specific conditions.

• Eligibility

Indian citizens aged 18 to 65 are eligible to open an NPS Tier-1 account. Non-Resident Indians (NRIs) can also participate in the scheme.

• Minimum and Maximum Contributions

Subscribers must contribute a minimum of ₹1,000 annually, with no cap on the maximum amount. Contributions can be made on a monthly, quarterly, half-yearly, or annual basis.

• Tax Advantages

Investments in NPS Tier-1 accounts qualify for tax deductions under Section 80C of the Income Tax Act, 1961, up to a limit of ₹1.5 lakh. Additionally, salaried individuals can claim an extra ₹50,000 deduction under Section 80CCD(1B).

• Returns

The returns on NPS Tier-1 investments are market-linked, depending on the performance of the selected fund and the asset allocation. Subscribers can invest in a mix of equity and debt funds, offering flexibility to align investments with their risk tolerance.

• Maturity and Withdrawal

Upon reaching 60 years, subscribers can withdraw 60% of the accumulated corpus, which is exempt from tax. The remaining 40% must be used to purchase an annuity from an IRDA-regulated insurance company, ensuring a regular pension for life.

2. NPS Tier 2 Account

An NPS Tier 2 Account is a voluntary savings account under the National Pension System (NPS) in India. It offers flexibility for subscribers to withdraw their savings at any time, unlike the Tier 1 account, which has restrictions on withdrawals as it is primarily designed for retirement savings.

• Optional Account

The NPS Tier 2 account is not mandatory and serves as an add-on to the Tier 1 account. You can only open a Tier 2 account if you already have an active Tier 1 account, which acts as the primary retirement savings account under the National Pension System. Unlike Tier 1, which is focused on long-term retirement savings, Tier 2 offers greater flexibility and liquidity for short-term financial goals.

• No Lock-in Period

One of the standout features of the Tier 2 account is its complete liquidity. You can deposit and withdraw funds as needed, with no restrictions or penalties. This makes it an attractive option for individuals who want to use it as a savings or investment account while still benefiting from professional fund management.

However, government employees who avail of a tax deduction under Section 80C have a mandatory 3-year lock-in period for Tier 2 contributions.

• Investment Flexibility

Like the Tier 1 account, the Tier 2 account provides multiple investment options across different asset classes:

• Equity (E): Invests in equity markets, ideal for those seeking higher returns with higher risk.
• Corporate Bonds (C): Invests in debt instruments issued by corporations, offering moderate risk and returns.
• Government Securities (G): Invests in government bonds, ensuring low risk with stable but lower returns.

Subscribers can choose a fund manager to handle their investments or switch between fund managers if needed. Investment allocation can also be customized manually or set to auto mode, where the allocation changes based on the subscriber’s age.

• Taxation

Unlike the Tier 1 account, contributions to the Tier 2 account are not eligible for tax deductions under Section 80C of the Income Tax Act. Also, earnings from the Tier 2 account (capital gains, dividends, etc.) are taxable as per the subscriber’s applicable income tax slab. Withdrawals are also fully taxable, making the Tier 2 account less attractive for individuals focused on tax savings.

• No Employer Contribution

Contributions to the Tier 2 account are entirely voluntary and come only from the subscriber. There is no provision for employer contributions, as the Tier 2 account is designed to serve as a personal savings or investment tool rather than an employer-linked benefit.

NPS Tax Benefits

National Pension Scheme offers several tax advantages.

1. Tax Benefits for Employees

Employees can avail the following tax advantages under the NPS:

• Tax Deduction Under Section 80CCD(1): Employees can claim a tax deduction of up to 10% of their salary (Basic + DA) under Section 80CCD(1) of the Income Tax Act, subject to the overall limit of ₹1.50 lakh under Section 80CCE.
• Additional Deduction Under Section 80CCD(1B): Employees are eligible for an additional deduction of up to ₹50,000 under Section 80CCD(1B), beyond the ₹1.50 lakh ceiling set under Section 80CCE.

2. Tax Benefits for Employers

Employers can benefit from the following deductions under NPS:

• Employer’s Contribution Under Section 80CCD(2): Employers can claim tax deductions for their contribution to NPS, up to 10% of the employee’s salary (Basic + DA) under Section 80CCD(2). For central government employees, the employer's contribution can go up to 14%. This is above and beyond the ₹1.50 lakh limit under Section 80CCE.

3. Tax Benefits for Self-Employed Individuals

Self-employed individuals can avail of the following tax advantages under NPS:

• Tax Deduction Under Section 80CCD(1): Self-employed individuals can claim tax deductions of up to 20% of their gross income under Section 80CCD(1), in addition to the ₹1.50 lakh limit under Section 80CCE.
• Additional Deduction Under Section 80CCD(1B): An additional deduction of up to ₹50,000 can be claimed under Section 80CCD(1B) beyond the ₹1.50 lakh limit.

4. Tax Benefits on Partial Withdrawal

Partial withdrawals from the NPS account are eligible for the following tax benefit:

• Exemption on Withdrawal Under Section 10(12B): Up to 25% of the total contribution can be withdrawn tax-free.

5. Tax Benefits on Annuity Purchase

Upon purchasing an annuity after turning 60 or on superannuation, an individual can claim:

• Tax Exemption on Annuity Under Section 80CCD(5): Individuals can claim tax exemption for the purchase of an annuity under Section 80CCD(5) of the Income Tax Act. However, the returns from the annuity will be taxed as per Section 80CCD(3).

6. Tax Benefits on Lump-Sum Withdrawal

Upon reaching the age of 60 or superannuation, individuals are entitled to the following tax benefit on lump-sum withdrawal:

• Exemption on Lump-Sum Withdrawal Under Section 10(12A): The lump-sum withdrawal of up to 60% of the total pension corpus will be tax-exempt.

7. Tax Benefits for Corporates/Employers

Corporates and private employers can claim tax deductions for their contributions under the following provision:

• Employer’s Contribution as Business Expense: Under Section 36(1)(iv)(a) of the Income Tax Act, the employer’s contribution to an employee’s NPS account is deductible as a business expense from the Profit & Loss account. The deduction can be up to 10% of the employee’s salary (Basic + DA).

Who is Eligible to Open an NPS Account?

You are eligible to open an NPS account if you are an Indian citizen, whether a resident, non-resident, or an Overseas Citizen of India (OCI), provided you meet the following criteria:

• You must be between 18 and 70 years old at the time of submitting your application, either to a Point of Presence (PoP) / PoP-Service Provider (PoP-SP) or online via e-NPS.
• You must adhere to the Know Your Customer (KYC) norms as specified in the Subscriber Registration Form (SRF) and submit all necessary documents for KYC compliance.

Please note that Hindu Undivided Families (HUFs) and Persons of Indian Origin (PIOs) are not eligible to subscribe to NPS.

What is the Contribution Required for NPS Tier 1 and Tier 2 Accounts?

How to Open an NPS Account?

Option 1: Online Method (eNPS)

• Visit the Official eNPS Website

Go to the official NPS website: https://enps.nsdl.com.

• Create an Account

Click on "Subscriber Registration" and choose whether you are registering as an Individual or Corporate.

• Fill Out the Registration Form

Enter your personal details, such as:

• Name
• Date of birth
• Address
• Email ID
• Mobile number
• Nominee details

• Upload KYC Documents

You will need to submit KYC documents, which may include:

• Proof of identity (Aadhaar, PAN, Passport, etc.)
• Proof of address (Aadhaar, utility bill, etc.)
• Bank account details

• Make the Initial Contribution

After successfully registering, make your first contribution to the NPS account (₹500 or more) using your preferred payment method (debit/credit card, net banking, etc.).

• eNPS Verification

Verify your details using your Aadhaar number and e-sign the application, or you can choose to submit physical documents if Aadhaar authentication is not available.

• Receive Permanent Retirement Account Number (PRAN)

After verification, you will receive a PRAN number, which is your unique NPS account number. You can start contributing to your NPS account once you have the PRAN.

Option 2: Offline Method (Through PoP - Point of Presence)

• Locate a PoP

Visit a PoP (Point of Presence), which are authorized agents or institutions (such as banks, financial service providers) that offer NPS services.

• Fill the Subscriber Registration Form (SRF)

Complete the Subscriber Registration Form (SRF) provided by the PoP, and submit the required KYC documents for verification.

• Submit the Form and Documents

Hand over the completed form and documents to the PoP. You will need to provide identification proof, address proof, and a photograph.

• Make the First Contribution

Pay the initial contribution (₹500 or more) to activate your NPS account.

• Receive Your PRAN

After processing your application, the PoP will issue a Permanent Retirement Account Number (PRAN), and you will be able to start contributing to your NPS account.