NPS Tier 1 vs. Tier 2 Account

What is the National Pension Scheme?

The National Pension System (NPS) is a government-backed, voluntary long-term retirement savings scheme launched in 2004 to help individuals build a secure financial future post-retirement. Open to both residents and non-residents aged 18 to 70, NPS operates on a contributory basis involving both employee and employer contributions. It offers two account types—Tier 1 for retirement savings and Tier 2 for flexible investments: with a variety of asset classes to choose from, including equity, corporate bonds, and government securities.

Important Update: Impact of Tax Regimes on NPS Deductions

NPS Benefit Updates in Old vs. New Tax Regime:

• You can claim tax deductions under the old tax regime for your NPS contributions under Section 80CCD(1), Section 80CCD(2) and Section 80CCD(1B) of the Income Tax Act, 1961.
• Under the new tax regime, tax deductions under Section 80CCD(1), Section 80CCD(2) and Section 80CCD(1B) are not available.
• However, Section 80CCD(2) (employer's contribution) is available under both tax regimes.

What are Tier 1 and Tier 2 in NPS?

The National Pension Scheme offers two types of accounts for subscribers: Tier 1 and Tier 2, each with distinct features and benefits. You contribute to the accounts during your earning years to reap the benefits of the corpus as you retire at 60 years of age.

Tier 1 Account:

This is the default and mandatory account under NPS, intended for long-term retirement savings. It comes with withdrawal restrictions and requires partial annuitization at maturity. The structure encourages disciplined investing for retirement and is eligible for tax benefits, as outlined under applicable income tax sections.

Tier 2 Account:

This is an optional, flexible investment account that allows unrestricted withdrawals. It can only be opened if you have an active Tier 1 account. While Tier 2 generally does not offer tax benefits, central government employees are an exception — they can claim tax deductions on Tier 2 contributions under specific conditions as per government notifications. For most other subscribers, Tier 2 functions as a liquid, market-linked investment vehicle without tax incentives.

Similarities Between NPS Tier I and Tier II

• Government-Sponsored Pension Plans: Both Tier 1 and Tier 2 accounts are pension plans backed by the Government of India, offering a secure and regulated framework for retirement savings.
• Incur Similar Charges: Both Tier 1 and Tier 2 accounts in terms of fund manager, custodian, and transaction fees cost the amount of charges.
• Professional Fund Management: Funds are managed by expert fund managers across multiple asset classes.
• Permanent Retirement Account Number (PRAN): A unique PRAN is allotted for both accounts.
• Portability: Accounts can be transferred across jobs and locations.
• Flexibility: Both accounts offer flexibility to change fund managers and asset allocation.
• Wealth Creation Potential: Both tiers offer compounding benefits over time.

Difference Between NPS Tier 1 vs. Tier 2

All savings are provided by the insurer as per the IRDAI-approved insurance plan. Standard T&C Apply

Tax benefit is subject to changes in tax laws. Standard T&C Apply

Tax Benefits on NPS Tier 1 and Tier 2 Returns

Understanding the tax advantages associated with NPS can help you make informed investment decisions aligned with your financial goals. Both salaried and self-employed individuals can enjoy certain tax benefits under the Income Tax Act, depending on the type of NPS account and the tax regime selected.

1. Tax Benefits for Salaried Individuals – NPS Tier 1

   If you are a salaried employee, contributions made to your Tier 1 NPS account can qualify for tax deductions under the following provisions:

   • Under Section 80CCE, NPS Tier 1 subscribers are eligible to claim a tax deduction of up to ₹1.5 lakh.
   • Contributions made by the employee fall under Section 80CCD(1). However, the combined limit across Sections 80C to 80CCD(1) is capped at ₹1.5 lakh. An additional deduction of ₹50,000 can be claimed separately under Section 80CCD(1B) for individual contributions, beyond the ₹1.5 lakh ceiling.
   • Additionally, contributions made by the employer qualify for tax benefits under Section 80CCD(2), which are not included in the ₹1.5 lakh limit. Employer's contribution to NPS can be claimed up to 14% of the basic salary, under the new regime and 10% of the basic salary for the old regime.

2. Tax Benefits for Self-Employed Individuals – NPS Tier 1

   • If you are self-employed, the benefits differ slightly:
   • You can claim a deduction of up to 20% of your gross total income, capped at ₹1.5 lakh under Section 80CCE, through your own contributions under Section 80CCD(1).
   • Like salaried individuals, you can also avail an additional ₹50,000 deduction under Section 80CCD(1B), exceeding the standard ₹1.5 lakh limit.

3. Tax Benefits for Tier 2 NPS Account

   • If you're a central government employee, contributions made to your Tier 2 NPS account may qualify for tax deduction under Section 80C, but only if the investment is held for a minimum lock-in period of 3 years.
   • For private sector employees, state government employees, or self-employed individuals, there are no tax benefits available for Tier 2 contributions.

4. Tax Treatment on Withdrawals and Account Closure

   • Tier 1 Account: Upon reaching 60 years of age, you can withdraw up to 60% of the accumulated corpus tax-free, while the remaining 40% must be used to purchase an annuity, which is taxable as per your applicable income slab.
   • Premature withdrawal: Premature withdrawal from Tier 1 is allowed only after 3 years of continuous investment, and you can withdraw up to 25% of your own contributions, limited to three times during the tenure. Employer contributions cannot be withdrawn prematurely.
   • Tier 2 Account: Offers flexible withdrawal without any lock-in. There is no tax exemption on withdrawals, except for central government employees who meet the lock-in condition.

NPS Tier 1 vs. Tier 2 – Which Should You Opt For?

Since Tier 1 is the primary and mandatory account under the National Pension System, your choice really lies in whether you want to add a Tier 2 account alongside it. After understanding the key differences between the two, here are some points to help you decide:

• Tier 1 is suitable for long-term retirement planning with built-in discipline and tax benefits.
• Tier 2 is optional and offers high liquidity, functioning like a savings or investment account. However, it does not offer tax deductions (except for central government employees who meet certain conditions).
• Contributions in Tier 1 qualify for tax deductions of up to ₹2 lakh annually — ₹1.5 lakh under Section 80C and an additional ₹50,000 under Section 80CCD(1B).
• Upon retirement, 60% of the Tier 1 corpus can be withdrawn tax-free, while the remaining 40% must be used to purchase an annuity, which provides regular post-retirement income.
• Tier 2 offers full flexibility — funds can be withdrawn at any time without any lock-in period or penalty.

Hence, Tier 1 is essential for building a retirement corpus with tax benefits. If you’re looking for added flexibility and easier access to funds, you may consider opening a Tier 2 account alongside your Tier 1.

Conclusion

For building your retirement corpus, Tier 1 is more disciplined and tax-efficient. For short-term goals or emergencies, Tier 2 is suitable due to its liquidity. Based on your financial goals and flexibility needs, you may choose either or maintain both for better diversification.