What is NPS Tier II and how to use it

Activating NPS Tier II

The Tier I account under NPS is specifically meant to be a retirement vehicle which is why it has rather rigid restrictions on the early withdrawal of your funds and where you invest your maturity amount. The Tier II is a tag-on facility. It offers many of the benefits of Tier I but with greater flexibility to use your maturity proceeds as you like.  

To open a Tier II account, you need to be an NPS subscriber with a valid PRAN (Permanent Retirement Account Number). If you’d like to skip the Tier 1 account and jump straight to Tier 2 for its flexibility, sorry that’s not allowed.

However, having decided to sign up for NPS, you can activate your Tier II account right along with your Tier I account or leave it for later. To activate the Tier II account online, you need to submit your NPS PRAN (Permanent Retirement Account Number), PAN and Date of Birth, get an OTP, fill up an online application form on the eNPS  website and send the hard copy of this form along with a cancelled cheque and PAN copy to the NSDL Central Record Keeping Agency.

You can also open the account offline by submitting the same documents to the banks or intermediaries through which you open your Tier I account.

How’s it different?

Under each of the points below, we have tried to bring the difference in operation or treatment of Tier 1 and Tier II accounts.

#1 Contributions

 You can start off on your Tier I account with a contribution of Rs 500 and thereafter need make a minimum contribution of at least Rs 1000 per year one time, to keep the account active. In Tier II, you start off with an initial sum of Rs 1000 and thereafter can invest Rs 250 or more in any year. Contributing every year is not compulsory to keep the Tier II account alive. If you find yourself strapped for surpluses in any particular year, you can contribute only to Tier I and skip Tier II.

#2 Costs

 One of the biggest benefits of using NPS as a wealth creation vehicle is its low fund management fees that take a minimal bite out of your returns. Tier II accounts offer this benefit too. The different costs charged by NPS are classed under PoP charges, CRA charges and annual fees for the pension fund manager, custodian and NPS Trust.

For the Tier II account, PoP charges for transactions and fees to the pension fund manager, custodian and NPS Trust are exactly the same as for Tier I. However, the CRA charges for opening and maintaining your account are not levied given that you would have already incurring these on your Tier I account.

#3 Withdrawals

 The NPS Tier I account is much like a Chakravyuha – easy to get in, but difficult to exit. To prevent subscribers from tapping into their retirement funds for every little thing, the Tier I account imposes many restrictions on withdrawals before you turn 60. To make partial early withdrawals, you need to complete 3 years with the scheme and can only withdraw 25% of your own contributions (not the returns on it). There are conditions on end-use of this money and you can only apply for such withdrawals 3 times during your lifetime.

In the Tier II account though, you are free to withdraw your accumulated corpus at any time of your choice. But if you have equities in your Tier II portfolio, do abandon plans of withdrawing within 5 years. It would be desirable to give your investments 5-7 years to deliver as the rewards of equity investing cannot be reaped over shorter periods. If you apply for withdrawal of your Tier II balance, you will get the credit in your bank account in 3 working days.

At least 40% of your final maturity proceeds in Tier I must be mandatorily invested in annuities that give you a monthly pension, while you can only take home the remaining 60% as a lumpsum. In the case of the Tier II account though, there are no restrictions on how you deploy the maturity proceeds. You can blow it up on a Mediterranean cruise if you like (though we wouldn’t advise it). 

Here are 2 annuity plans that we have previously reviewed : HDFC Life Sanchay Plus & LIC Jeevan Akshay 7.

#4 Switches

 You can move money from your Tier II account to your Tier I account at any time. The transaction will be processed at the prevailing NAVs of the two schemes. But this is a one-way street and you cannot move money from your Tier I account back to your Tier II account, so make this decision wisely. Given that your Tier II account offers anytime liquidity and imposes no withdrawal conditions, it is best not to make this switch.  

#5 Nomination

 Your nominations for your Tier II account can be different from those for the Tier I account.

#6 Taxation

Your contributions to the Tier I account are eligible for tax exemptions totalling to Rs 2 lakh a year under section 80C and 80 CCD of the Income Tax Act (Read this article for the low-down on the taxation of Tier I ).

If you are a private sector employee or a self-employed person, your contributions to the Tier II account though are not eligible for these tax concessions, meant exclusively for retirement vehicles.

For Central government employees alone, contributions to the Tier II account are eligible for tax exemptions under section 80C (along with all the other options including EPF) subject to the overall limit of Rs 1.5 lakh per year. The contributions in this case are subject to a 3-year lock in period.

 The Tier I account offers pretty unfriendly taxation on your final maturity proceeds. At maturity, of every Rs 100 in your account (consisting of your contributions plus returns), at least Rs 40 needs to be used to buy annuities, while a maximum of Rs 60 can be taken home as lumpsum. While the Rs 40 is initially exempt from tax, the annuity income gets taxed at your slab rate when you receive it. The remaining Rs 60 in lumpsum is exempt from tax.

The final maturity proceeds from the Tier II account get no specific mention in the Income Tax Act and this makes the taxation subject to ambiguity. But given that the Tier II account offers no tax benefits on your contributions, some tax experts believe that your redemption amount on Tier II will not be subject to any special rules or restrictions.

One interpretation is that NPS being a market-linked vehicle, its maturity proceeds should be subject to capital gains taxation. However, as NPS units are not specifically defined as securities or chargeable to STT, long-term capital gains will apply if held for 3 years plus and short-term capital gains if held for less. The LTCG rate would then be at a flat 20% with indexation benefits on costs.  This however is just an interpretation and can be contested by the taxman until a specific provision is introduced.

In the worst case scenario, your gains may be taxed like any other income (say like interest on your FD) at your slab rate. Here again, this is just another possibility. There is no mention of this in the Income Tax or NPS provisions.

In July 2020, the Centre notified that Government employees who contribute to the Tier II account can avail of 80C benefits on their contributions, subject to the overall limit of Rs 1.5 lakh a year being available. However, government employees who opt for the Tier II option with tax breaks will be subject to 3-year lock in and specific limitation on asset allocation choices.

If you have other 80C options, it may make sense to opt for the non-tax exempt Tier II contributions so that you can enjoy greater flexibility.    

Making the choices

One of the big pluses of the NPS is the choices it offers to subscribers in terms of their asset classes and pension fund managers. Both these choices are available for Tier II accounts as well. Your choice of Pension Fund Manager and asset allocation for your Tier II account can be totally different from your Tier I account.

Fund managers

 On pension fund managers, it would be good to choose a different manager for your Tier II account, without compromising on the performance record, from the manager you picked for Tier I. This will provide fund manager and style diversification – you won’t have all your eggs in one basket. It may also reduce portfolio overlaps between your Tier I and Tier II accounts that could result in unnecessary duplication of holdings. To select your fund managers, do check out the performance record of each manager for Tier II accounts.

This excel sheet tells us that there could be significant variations in performance between Tier I and Tier II portfolios of the same managers. Do make your choices based on a 10-year track record covering two market cycles. 

Auto or Active

Just like in Tier I, when you activate your Tier II account, you get to choose between the Active and Auto choices to allocate your money. To maximise the return potential (We explained why in this article) it is best that you opt for the Active choice that allows you to be in the driving seat on deciding allocations between Equities (E), Corporate bonds (C ) and Government bonds (G).

What should this allocation be? Well, you should be guided by the following:

• If you plan to use your Tier II account for goals that are 10 plus years away, like retirement, maximise your equity allocation at 75%. However, a 75% equity allocation is only allowed for investors who are upto 50 years of age. Given that 10 years plus horizon can yield decent returns both in gilts and corporate bonds (G and C) while minimising the impact of interest rate swings, you can park the remaining 25% to the extent of 10% in C and 15% in G for the most returns. If you are extremely wary of credit risk though, you can invest the entire 25% in G.   
• If you plan to use the account for goals that are 7-10 years away, go in for a 50% equity allocation, with 50% in C and G. This can help protect your portfolio from downside if the equity market should go through a prolonged bear phase of 3-4 years during your investment period. Again, you can go in for 20% in C and 30% in G given the long holding period that is likely to smooth out rate cycles. 
• For goals that are 5-7 years away, go for a debt heavy portfolio at 60% divided equally between C and G. The rest can be in equities.
• For less than 5-year goals, stay off equities and stick only to the C and G options. Over short periods like less than 3 years, remember that returns from high quality corporate bonds (C) which earn steady interest accruals can prove a lot steadier than returns from government bonds, which can swing quite a bit on ups and downs in the rate cycle.
• Do moderate your equity exposures in the last 3 years heading up to your goal, so that your final maturity proceeds are not hit hard by any sudden downturn in stock markets.

How to use it

If you already have equity allocations in your portfolio via good multicap or large-midcap funds, the NPS Tier II account may not be very necessary to your retirement planning.

But if you are sold on the pluses of NPS as a retirement vehicle (it has a few – flexible switches, allocation to bonds, low fees), the Tier II account offers you a good vehicle to escape the rigidities and red tape of the Tier I account while still building a sizeable retirement corpus.

In this case, you can use the NPS Tier I account mainly to make use of section 80C and section 80CCD tax breaks and park any surplus you have over and above this limit in the Tier II account. The Tier II contribution will then fetch you market-linked returns at low fees while you continue to enjoy anytime liquidity and the freedom to use the final corpus as you like, without being forced to buy annuities.

To give a live example, suppose you can set aside Rs 2 lakh a year towards retirement but have room for just Rs 25,000 under section 80C, you can invest Rs 75000 in the Tier I account (Rs 25,000 under 80C plus Rs 50,000 under 80CCD) and plough the remaining Rs 1.25 lakh into the Tier II account. The latter can add sizeably to your retirement kitty without the restrictions on early withdrawal or the compulsion to invest the final corpus in annuities.

The Tier II account can come in handy to make your long-term bond allocations as the C and G options of NPS tend to outperform debt mutual funds by a good margin, thanks to their focus on high-quality bonds, buy-and-hold strategies and  ultra-low fees. In such cases, skip the E option entirely in your Active choice and max out C and G allocations in your Tier II account.

Also Read : Who’s the best NPS Fund Manager?