It’s tax saving season, so it’s apt to ask: Should you buy into the New Pension Scheme (NPS) for which the government has given you a phenomenal extra tax benefit of Rs. 50,000 next year?

The answer is complicated, so let’s go through the motions. Your choices are:

a) Invest the Rs. 50,000 into an NPS scheme, every year, for the next 20 years.

b) Pay taxes on the Rs. 50,000 (say at 30%) and invest the remaining Rs. 35,000 in a mutual fund instead.

Your Goal: To maximize what you earn out after taxes when you retire.

The NPS

So you put in Rs. 50,000 a year into the NPS for 20 years. Since 2009, the average return in the NPS schemes has been between 10% and 12% annualized, even including equity. Let’s take 11% as the growth number going forward.

You will end up with Rs. 32.10 lakh.

According to NPS rules you can “commute” 60% of that – meaning, take that much out as a lump sum. Currently about 50% of the 60% is not taxed, you have to pay tax on the remaining 10%. (See this tax department document that gives details) If you receive gratuity, the tax is even higher.

Let’s just take 10% as taxed – on reaching 60, 10% of Rs. 32.1 lakh will be considered, of which only 16.05 lakh commuted is tax free. You commute 60%, which is Rs. 19.2 lakh. Assume tax at 30% on the rest and you pay Rs. 96,000 in taxes, leaving you with Rs. 18.30 lakh.

So:

You can take out Rs. 19.26 lakh (60%), pay tax and be left with Rs. 18.3 lakh.

You buy an annuity with the remaining 12.84 lakh. At current LIC annuity rates, you’ll make 7.5% a year (your principal goes to your next of kin when you die). This translates to Rs. 8020 per month.

This pension payment is taxable, so assume a lower 20% slab you’ll get Rs. 6420 per month net of taxes. (Effectively, 6% post tax)

What of the amount of money you’ve taken out? The 19.26 lakh? Let’s say you just put it into an avenue that gives you a post-tax return of 8%.

That gives you a monthly income of Rs. 12,198.

Add it to the annuity, post tax monthly income is Rs. 18,618.

Negatives:

No flexibility till the age of 60. Cannot retire early, as premature withdrawals are added to income and taxed.

The need to buy an annuity reduces returns substantially, taking the net return to just 7%.

The Equity Strategy

Let’s say you buy the Nifty or a large and mid cap diversified mutual fund. These funds have, in the same time frame as the NPS, returned between around 14% annualized. Check this Value Research comparison, where out of 56 funds, even the median – 28th fund ranked by 5 year returns – has returned 14% in the 5 year term. Even five year returns of hybrid balanced funds are 13%+. Let’s still take just 13%.

We are investing Rs. 35,000 per year (since we decide to pay tax on the Rs. 50,000 and invest here).

We will end up with a corpus of Rs. 28.33 lakh. Since this is our own investment, there is no need to buy an annuity. Long term investments in equity are not taxed, currently. So we get all of the money, tax free.

Let’s say we take it all and put it again at 8% return post tax.

That yields us an income of Rs. 18,888 post tax.

Negatives:

There is higher risk of course. You never know that when you retire there may be this worldwide depression.

Note: If you see something wrong in the calculations, please let us know.

Wow: NPS is Not Good Enough!

All this drama of saving some extra tax with the NPS gives you no real advantage, it turns out. You get 18,888 per month if you buy the longer-term equity fund, versus Rs. 18,618 per month with the NPS. This is due to the convoluted taxable nature of the returns of the NPS.

We assumed 11% return for NPS and 13% for long term equity investment. If long term equity returns are 2% greater than the NPS, it is simply better to invest with long term equity mutual funds and pay the tax to the government instead. The return is substantially lowered because of tax implications at this point.

The do-it-yourself approach gives you additional flexibility of adding more money when you like, and taking out money early if you want an earlier retirement, with almost zero tax implications. And then, if you have a medical emergency at the age of 59 and need money desperately, you can’t touch your NPS money without “explaining” to the government why you need it early, and even then you have to pay tax on it. With your own money in equity, you don’t get no questions, and you don’t get no tax either. The additional tax-work of NP

Tax policies may change. Annuities may increase. But as it stands today, it’s just plain better to put your money into long term equity investments. Mutual funds are one thing, long term direct equity investments might be just as good, if you can spend some time understanding markets. I have personally seen instances of 40X returns over 18 years and that is 23% annualized, greater than anything else available since. Today, market’s are at a high, but it doesn’t mean markets stay that way – the simplest way to invest is to just keep investing over a long period of time, and take out money only when you need it.

The complications of an NPS and the tax-mess that they involve, plus the resulting lack of access to your own money is a huge bummer. It might also not even be as lucrative as an equivalent long term investment in equity funds, as we have seen above.