NPS Tier II Account vs. Mutual Funds

Most people do not have clarity on which options suit their needs - NPS Tier II Account or Mutual Funds. Many options are available in the market for both categories, which makes it critical to choose an option as per the needs and goals. Let us dive deep and clear the air around NPS and mutual fund investment strategies.

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NPS Tier II Account

The National Pension Scheme (NPS) is part of the scheme launched by the Government of India in 2004. It is managed by the Pension Funds Regulatory and Development Agency (PFRDA). 

The scheme provides an opportunity to the client in the 18-60 age groups to create a retirement fund to live a worry-free retirement life. NPS schemes help do that.

The scheme allows the customer an option to invest in Tier I or even both plans at the same time: 

  • Tier I – The account under the SBI NPS scheme does not allow the customer to withdraw any amount invested. This is a mandatory account and offers tax benefits to the account holders. 

  • Tier II – The account can only be opened by investors who already have a Tier I account. The consumers are allowed to withdraw funds from this voluntary account. 

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Features of an NPS Tier-II Account

Some major features of NPS Tier-II Account are:

  • Voluntary account: The National Pension Scheme Tier II account is not mandatory. However, to open the account, members must have a Tier I account. 

  • Contribution amount: The minimum account balance when the new NPR Tier II account is opened is Rs 1000. 

  • Tenure: There is no lock-in period for the Tier II accounts. There is an option for the government employees to claim tax benefits from the scheme if they have kept their investments for a minimum of 3 years.

  • Withdrawal: There is no withdrawal restriction if the account holder wishes to withdraw funds. They have the option to take out all the funds sitting in the Tier 2 NPS account as a lump sum or multiple instalments. 

  • Taxation: Investments made in Tier-II NPS account are not eligible for any tax benefit. The withdrawals are part of the customer's total taxable income and are taxed as per the client's individual income tax slab.

  • Transfer: The clients have an option to transfer funds from Tier II to Tier I accounts.

Mutual Funds

There are many misconceptions about mutual funds and its use. The financial risks associated with mutual funds make people sceptical. A mutual fund collects money from all the sources and invests it in different securities. 

They are beneficial for beginner or individual investors to allow their funds to be professionally managed at a low price. The total amount can be allocated into different categories depending on the type of security, the investment objective and the type of returns sought. 

Types of Mutual Funds

Equity Funds: According to the Investment Company Institute (ICI), Equity funds comprise more than 50% of the mutual funds. They have a higher potential to grow but are also volatile. The funds can be sliced into different categories depending on the goals and size of the fund. 

  • Large-Cap Fund

  • Mid-Cap Fund

  • Small-Cap Fund

Debt Funds: A debt fund is a mutual fund that invests in fixed income instruments. The fund investment can be in government and corporate bonds, corporate debt securities, etc.

Balanced Funds: Balanced Funds are a combination of equity and fixed-income funds with a fixed ratio of investments, forex: 70% stocks and 30% bonds

Bond Funds: As the name suggests, bond funds are the most common type of fixed-income mutual funds, where the investors are paid some amount back on their initial investment after a specific time. 

The second most common type of mutual funds usually invests in government and corporate debt. This is considered to safer investment and has less potential to grow as compared to Equity funds.

Money Market Funds: As per ICI, the Money Market Funds comprise of 15% mutual funds market and investors generally invest in high-quality, short-term debt from the government, banks, or corporations

Difference NPS Tier II and Mutual Funds

Feature NPS Tier II Mutual Funds 
Asset Allocation
  • NPS Account holders have an option to select between Auto Choice & Active Choice.
  • Under Active Choice, the investors have an option to deposit in a government bond, corporate debts, etc. 
  • The maximum allocation can go up to 75% of the total portfolio amount till the client is 50 years old. 
  • Then the maximum permitted equity proportion reduces by 2.5% annually to 50% at the age of 60. 
  • Those who have limited knowledge to manage their fund allocation can choose Auto Choice. 
  • Auto choice provides an option to select from 3 funds –Moderate Life Cycle Fund, Conservative Life Cycle Fund, and Aggressive Life Cycle Fund with a maximum equity cap of 75%, 50%, and 25%, respectively till the investor turns 35 years. 
  • After this, the equity reduces rapidly as age increases asset in asset allocation. 
  • Equity mutual funds allow at least 65% portfolio investment inequities. 
  • In the case of large and mid-cap funds, the limit can go up to 80% and 70% respectively. 
  • As the equity in assets class gives a much better return than any other asset class, equity mutual funds would perform better than the NPS over an extended period. 
  • Those who lack high-level skills can still consider investing in balanced advantage funds, hybrid funds, and multi-asset allocation funds. 
  • This investment changes the exposure to equity and other classes based on market conditions. 
Tax exemption on investments
  • All the options available under NPS are eligible for an additional deduction of up to Rs 50,000 under 80 CCD (1B).
  • This is other than the Section 80C deduction available for up to Rs 1.5 lakhs. 
  • Investments in Tier-II accounts are not eligible for any tax deductions. 
As far as mutual funds are concerned only Equity Linked Savings Schemes (ELSS) qualify for tax exemptions of up to Rs 1.5 lakh under Section 80C.
Taxation on Withdrawals and Maturity
  • Under NPS, 40% of the maturity amount must be used for purchasing annuities. You can withdraw the remaining amount as per your needs. 
  • The share of the fund used to purchase is tax-free but the income from derived interest is not tax-free. 
  • Any capital gains that you get on redemption of equity mutual funds are subject to 10% LTCG tax. 
  • Tax is only applied to gains above Rs 1 Lakh in a financial year.
  • One of the major drawbacks of NPS is its lack of liquidity. 
  • A client can withdraw prematurely only after 10 years of subscription.
  • Partial withdrawals not exceeding 25% of the investment are allowed after 3 years.
  • In case you withdraw prematurely, around 80% of the NPS corpus must be used to purchase annuities. 
  • Tier II NPS account has restrictions on account closure or redemption. 
  • There are no restrictions on withdrawals from mutual funds except in close-ended funds and the general 3-year lock-in period. 
  • Investors can withdraw and re-invest based on the market changes. 

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

In Conclusion

In investments, one criterion does not fit all. Everyone has different goals, objectives, and investment capacities. For a capital growth goal, equity mutual funds are a better option. 

NPS should be your choice if you are planning to create a retirement corpus with regular investments over the long term. You should be careful before making these decisions and should do intense research before investing in any scheme.


*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
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