NPS Tier 1 vs. Tier 2 Account

NPS Tier 1 vs. Tier 2 accounts are two distinct investment options offered under the National Pension System (NPS) in India. While both aim to secure financial futures, they differ in key aspects such as withdrawal flexibility, investment choices, and accessibility. Understanding the specifications of NPS Tier 1 and Tier 2 accounts is crucial for you to plan your retirement and prepare optimal investment strategies.

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Overview of NPS – National Pension Scheme

The National Pension System (NPS) is a voluntary long-term retirement savings scheme introduced by the Government of India. Launched in 2004, NPS aims to provide you with financial security during your retirement years from the age of 60 years. It operates on a contributory basis, where both employees and employers contribute to the pension fund.

Key Features of NPS:

  • Both residents and non-residents between the ages of 18 and 70 can participate

  • NPS consists of two tiers - Tier 1 and Tier 2

  • Participants can choose from a range of investment options, including equity, government securities, corporate bonds, and alternative assets.

  • Each subscriber is allotted a unique Permanent Retirement Account Number (NPS - PRAN) to track and manage their NPS account.

  • Contributions to NPS are eligible for tax deductions under Section 80CCD(1), 80CCD(1B), and 80CCD(2) of the Income Tax Act, 1961

  • You can also claim tax benefits on partial withdrawals from a Tier 1 account under certain conditions as per Section 10(12B) of the IT Act.

IMPORTANT UPDATE:

NPS Benefit Updates in Old vs. New Tax Regime:

  • You can claim tax deductions under the old tax regime for your NPS contributions under Sections 80C, 80CCD(1), and 80CCD(1B) of the Income Tax Act, 1961.

  • Under the new tax regime, you can not claim tax deductions for your NPS contributions under Section 80C, 80CCD(1), and 80CCD(1B).

People also calculate: NPS Pension Calculator

What are Tier 1 and Tier 2 in NPS?

The National Pension Scheme revolves around the Tier 1 and Tier 2 NPS accounts with varying connotations for the subscriber.  You contribute to the accounts during your earning years to reap the benefits of the corpus as you retire at sixty years of age. 

  • The Tier 1 account is mandatory, where you contribute till you retire. 

  • The Tier 2 account, on the other hand, is optional, with no compulsion to contribute, but it supplements your retirement corpus. 

The primary difference is that the Tier 1 account is rigid about withdrawals, while the Tier 2 account is flexible and liquid. 

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Similarities Between NPS Tier 1 and Tier 2

  • Government-Sponsored Pension Plans: Both NPS Tier 1 and Tier 2 are government-sponsored pension plans in India.

  • Voluntary Contributions: Both tiers allow you to make voluntary contributions towards your retirement savings.

  • Withdrawal Restrictions: Both tiers have restrictions on premature withdrawals, with specific conditions for accessing funds before retirement.

  • Professional Fund Management: Both tiers involve professional fund management, with investment options like equity, corporate bonds, and government securities.

  • Permanent Retirement Account Number (PRAN): You get a Permanent Retirement Account Number (PRAN) for both Tier 1 and Tier 2 accounts, which remains the same across both tiers.

  • Pension Annuity: Both tiers provide the option to use the accumulated corpus to purchase a pension annuity upon retirement.

  • Portability: Both NPS tiers offer portability, allowing you to transfer your accounts between different sectors and locations.

Difference Between NPS Tier 1 vs. Tier 2

The major NPS Tier 1 and Tier 2 differences are listed in the table mentioned below:

Parameter Tier 1 Account Tier 2 Account
Eligibility
  • Mandatory with NPS membership
  • Provides a valid PRAN
  • Optional account
  • It requires a Tier 1 account opening first.
Contribution
  • Open with Rs. 500
  • You must deposit Rs.1000 annually
  • No limit on maximum contributions
  • No compulsion for regular contributions
  • Minimum Rs. 1000
  • No limit on maximum contributions
Lock-in Period Locked until age 60 (retirement). No lock-in; withdraw anytime.
Return on Investment
  • Market-driven returns
  • 9% to 15% returns
  • No tax benefits for contributions
  • Flexibility of withdrawals
Tax Benefits (Investment) Eligible for deductions under Section 80CCD and Section 80CCE No tax benefits for contributions
Tax Benefits (Maturity) Tax-exempt withdrawals No tax benefits
Purpose Retirement saving plan. Regular investment plan.
Investment Choice Active or Auto-choice Active choice
Annuity 40% maturity amount must be used to buy an annuity plan. Not applicable
Account Maintenance Charges (AMCs) Applicable Not Applicable
Partial Withdrawal Allowed for 25% of the invested amount after 3 years of investment, up to a maximum of three times Can withdraw anytime without conditions

*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."

Benefits of NPS Tier 1 and Tier 2 Accounts

The key advantages of NPS Tier 1 vs Tier 2 accounts are as follows:

  1. Tier 1 - Retirement Savings:

    • Long-term savings for retirement.

    • Tax benefits under Section 80C and 10(12A)

  2. Tier 2 - Flexible Withdrawals:

    • Allows anytime withdrawals for various needs.

    • There is no lock-in period offering liquidity.

  3. Common Benefits:

    • Professionally managed by fund managers.

    • Low-cost structure for higher returns.

    • Government-backed, ensuring security.

  4. Wealth Creation:

    • Potential for wealth accumulation over time.

    • Systematic contributions lead to compounding benefits.

  5. Tax Efficiency:

    • Tax advantages during investment and withdrawal stages.

    • Enables tax planning and optimization.

  6. Portability:

    • Transferable across jobs, ensuring continuity.

    • Offers flexibility for changing financial goals.

NPS Tier 1 Vs. Tier 2 – Which to Choose?

After comparing Tier 1 and Tier 2 NPS accounts, you now understand their pros and cons. Consider these points:

  • Tier 1 is less flexible for financial emergencies compared to Tier 2.

  • Tier 1 is rigid, while Tier 2 operates like a regular savings account.

  • Tier 1 offers more tax benefits during investment and maturity, but Tier 2 provides flexibility for retirement savings.

  • Tier 1 has a lock-in period until age 60, while Tier 2 allows anytime withdrawals.

In Tier 1, 60% of the corpus is received at maturity, with the remaining 40% used for an annuity plan, providing regular income. Tier 2 lacks this feature.

Tier 1 investments offer tax savings of up to Rs. 62,400 yearly, while Tier 2 provides no tax benefits.

For a robust retirement corpus with tax savings and discipline, prefer Tier 1. For flexibility, allocate some funds to Tier 2. The choice depends on your financial goals and flexibility needs.

In Conclusion!

The choice between NPS Tier 1 and Tier 2 accounts depends on individual financial goals and needs. Tier 1 is designed for long-term retirement planning with restrictions on withdrawals offering tax benefits. On the other hand, Tier 2 provides more flexibility for short-term financial goals with unrestricted withdrawals but lacks the same tax advantages. You should carefully evaluate your objectives and risk tolerance before deciding on the most suitable NPS account type for your financial strategy.

FAQ's

  • What happens to the Tier 1 balance if the subscriber expires before turning sixty?

    If an NPS subscriber passes away before reaching the age of 60, the accumulated corpus in their Tier 1 account will be paid to their nominee or legal heir. This is the same procedure that applies to the Tier 2 account.
  • Is the income from the annuity purchased using the Tier 1 corpus taxable?

    No, the income from the annuity purchased using the Tier 1 corpus is not taxable.
  • What role does the fund manager play in the NPS?

    In the National Pension System (NPS), fund managers play a crucial role in managing the investments of NPS subscribers and ensuring the growth of their retirement corpus. They are responsible for making informed investment decisions based on their expertise and market analysis, aiming to maximize returns while minimizing risks.
  • How is the NPS return rate determined?

    The National Pension System (NPS) is a market-linked retirement savings scheme, and its returns are primarily determined by the performance of the underlying investments. 

    The return rate for each NPS scheme is calculated based on the following factors:

    • Asset Allocation

    • Market Performance

    • Fund Manager Skills

    • Reinvestment of Returns

    • Fees and Expenses

  • Is there any provision for withdrawal from the Tier 1 NPS account?

    Yes, there are certain provisions for withdrawal from the Tier 1 NPS account under specific circumstances.
    • Partial Withdrawals:

      • After 3 years of account opening

      • specific financial emergencies, such as illness, education expenses, or the purchase of a house

    • Complete Withdrawals:

      • Attainment of 60 years

      • Early exit is subject to certain penalties and restrictions.

  • Which is better, NPS Tier 1 or Tier 2?

    NPS Tier 1 is a better choice for individuals who are primarily focused on saving for retirement and want to take advantage of tax benefits. NPS Tier 2 is more suitable for those who need flexibility in their savings and may require access to funds before reaching retirement age.
  • Is Tier 2 NPS taxable?

    No, contributions made to the NPS Tier 2 account do not qualify for any tax deductions under the Income Tax Act. However, withdrawals from the Tier 2 account are taxable at a flat rate of 20% after indexation if held for more than 36 months.
  • Is NPS Tier 1 tax-free?

    Yes, NPS Tier 1 is tax-free. Following are the specific tax benefits of NPS Tier 1:
    • Tax deduction on contributions: You can deduct up to Rs. 1.5 lakhs from your taxable income under Section 80C of the Income Tax Act.

    • Additional tax deduction of Rs. 50,000: You can claim an additional tax deduction of up to Rs. 50,000 under Section 80CCD(1B) of the Income Tax Act.

    • Tax-free returns: The returns from your NPS Tier 1 account are completely tax-free at the time of withdrawal.

  • Can I transfer money from Tier 1 to Tier 2?

    No, you cannot transfer money from Tier 1 to Tier 2. The movement of funds is only allowed from Tier 2 to Tier 1, not vice versa.

*All savings are provided by the insurer as per the IRDAI approved insurance plan.
*Tax benefit is subject to changes in tax laws. Standard T&C Apply
^The tax benefits under Section 80C allow a deduction of up to ₹1.5 lakhs from the taxable income per year and 10(10D) tax benefits are for investments made up to ₹2.5 Lakhs/ year for policies bought after 1 Feb 2021. Tax benefits and savings are subject to changes in tax laws.
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^^The information relating to mutual funds presented in this article is for educational purpose only and is not meant for sale. Investment is subject to market risks and the risk is borne by the investor. Please consult your financial advisor before planning your investments.

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