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Investing in NPS to Save Tax

How Investing in NPS can Help you Save Tax

National Pension Scheme (NPS) is best defined as a systematic and voluntary contribution of pension to all the employees of the Indian Government. Introduced on 10th October 2003, NPS has the primary purpose of providing a source of retirement income for all the employees in India working for the Indian Government. When it was first launched it was available exclusively for the government employees only, but now it is open for all. NPS is aimed to develop the habit of saving up funds when retirement approaches.

Top banks in India offering NPS

National Pension Scheme is a voluntary scheme, and the aim behind the scheme is to provide pension after retirement. You can invest in NSP through different means. However, the primary categories are Central Government Scheme, State Government Scheme, as well as the Swavalamban Scheme. You can also invest in National Pension Scheme through the following banks and financial institutions in India:

  • HDFC Bank: HDFC Pension Fund
  • Kotak Bank: Kotak Pension Fund
  • UTI Bank: UTI Pension Fund
  • Reliance: Reliance Pension Fund
  • LIC: LIC Pension Fund
  • SBI: SBI Pension Fund
  • ICICI: ICICI Pension Fund

Tax saving benefit under NPS at the time of investing.

The investment made under the National Pension scheme is eligible for tax exemption under three sections of the Income Tax Act, 1961:

  1. Section 80CCD (1)
  2. 80CCD (2)
  3. 80CCD (1b)

Tax benefits in NPS Tier 1 account

NPS ContributionSectionTax deduction limit
Employee’s contribution80CCD(1)10% of salary, maximum up to Rs. 1,50,000Under Section 80C
Self-contribution to NPS80CCD(1b)Rs. 50,000In addition to Section 80C + 80CCD(2)
Employer’s contribution80CCD(2)10% of salary (without monetary limit)In addition to Section 80C and 80CCD(2)

Employee’s contribution - Section 80CCD(1)

Tax benefit under Section 80CCD(1) is available for individuals who have contributed to their NPS Tier-1 account. Presently, an individual can claim income tax benefit on a maximum self-contribution of Rs. 1,50,000 in a financial year to their Tier-1 account. The amount deposited up to Rs. 1,50,000 can be claimed as a deduction from the income before tax, thereby reduces the tax liability.

Hence, even if you have deposited more than Rs. 1,50,000 in your Tier-1 NPS account, you will be able to claim tax benefit only up to Rs. 1,50,000 as per the income tax law. Remember, there is no upper limit on the amount that can be deposited in the Tier-1 NPS account.

This tax deduction comes under the overall limit of Section 80C of the Income Tax Act 1961. Current income tax law allows a maximum deduction of Rs. 1,50,000 on aggregate basis for the investment and expenditure incurred under Sections 80C, 80CCD and 80CCD(1).

Self-contribution to NPS – Section 80CCD(1b)

Apart from the tax-saving benefits mentioned above, an individual can claim deduction under Section 80CCD(1b) up to Rs. 50,000 in a financial year. This additional deduction came into existence in the financial year 2015-16.

This additional tax benefit is over and above tax break under Section 80CCD(1) and 80CCD(2). The amount deposited in NPS can be claimed as a tax deduction from total income before computing the liability, also called as gross income.

Employer’s contribution – Section 80CCD(2)

When the employer deposits the funds on behalf of the individual in his/her NPS Tier-1 account, the individual can claim tax benefit under Section 80CCD(2). As per the current tax laws, the employer can deposit a maximum of 10% of the individual’s salary (basic salary + dearness allowances). There are no restrictions on how much can be deposited as long as it does not exceed the specified limit.

For government employees

From the Financial year 2019-20 onwards, government employees have an option to invest in NPS Tier-2 account with a lower lock-in period. A government employee is allowed to invest a maximum of Rs. 1,50,000 in Tier-2 account to claim income tax benefits under Section 80C. Unlike the Lock-in period till the age of retirement, the amount invested in Tier-2 account comes with a lock-in period of 3 years. It is important to note that the tax benefits offered for Tier-2 NPS account are not applicable to non-government employees.

Lock-in period for NPS and partial withdrawal facility

It is essential to note that NPS comes with a certain lock-in period, which is comparatively longer than the other types of investment options available in India, for instance, FD. The scheme matures once the individual reaches at the age of 60 years. However, during this lock-in period, partial withdrawals can be made as per the specified terms.

For instance, one can withdraw from their NPS account for the higher education of children, the marriage of children, construction or purchase of a residential house, etc., once the Tier-2 NPS account has completed 3 years for government employees.

The maximum amount that one can withdraw from Tier-1 NPS account is 25% of his/her own contribution. Moreover, as per the current income tax regulations, maximum 25% withdrawal from account holder's own contribution will be exempted from tax. Hence, the maximum amount of partial withdrawal and the tax exempted amount is the same. One can invest and save income tax by various investment products as specified under Section 80C of the Income Tax Act 1961. However, while making such an investment to save income tax, it is important to connect tax-saving investments with your financial goals.

National Pension Scheme comes with an extended lock-in period and certain terms regarding partial withdrawal. You might not be able to withdraw funds from your NPS account except for the specified situations. However, if your goal is to create a retirement corpus, the NPS is one of the good options that also offer tax benefits.