How NPS works for Central Government employees

While the National Pension System (NPS) has been opened up to all Indian citizens of late, employees who work with the Central government service have been contributing to NPS as their default pension scheme since January 1, 2004.

The features and tax rules of the NPS as they apply to Central government employees are quite different from those for ordinary folks. So, here’s all you need to know if you’re a Central government employee subscribed to the NPS. Let’s start with the Tier I account first.

Contributions

Prior to April 1 2019, Central government employees were required to contribute 10% of their basic pay plus Dearness Allowance to the NPS towards their retirement benefits, with their contribution being equally matched by the Central government. In a change of heart in early 2019, the Central government decided to raise its contribution to 14% of the employee’s basic pay plus DA. The higher contribution has kicked from April 1 2019. In addition, government employees can make voluntary additional contributions of upto Rs 50,000 a year to the Tier I account to avail of the additional tax break under section 80CCD (1B).

Investment choices

Ordinary citizens get to make two sets of choices relating to their investments in their main NPS Tier 1 account. One, they get to choose the assets in which their contributions will be invested, with the option of going for the Active choice or Auto choice (Read our article on how to plan your NPS asset allocation for the low-down on this). Two, they get to choose the pension fund manager who will manage their money. But the rules differ slightly for Central government employees.  

Pension Fund Managers:  Prior to April 1 2019, contributions from Central government employees were automatically divided in a predefined proportion between the three public sector managers – SBI, LIC and UTI Retirement. After a notification by the government in April 2019, however, Central government NPS subscribers have been green flagged to choose any of the seven designated pension fund managers – whether public or private. Their choices now include ICICI Pru Pension, Kotak Mahindra Pension, HDFC Pension and Birla Sunlife Pension in addition to the three public sector managers.

Do note that should you fail to exercise this choice, your contributions will be invested on a default basis into the Central government funds managed by SBI, LIC and UTI pension funds. These invest in government securities to the extent of 55%, other debt to the extent of 40% and equities to the extent of 15%.  These schemes have a long track record since 2008 and have managed impressive returns of 9.7-10.05% per cent since inception. (Refer here for performance)

But the high returns are a function of the high interest rates that have historically prevailed on government securities. With yields on government securities falling to sub-6 % in the last couple of years, you should expect the returns on these schemes to moderate. With direct retail access to government bonds improving, there’s also no reason for you to tie yourself into the onerous rules of the NPS just to invest in government bonds.

Allocation: Don’t ask us why, but Central government subscribers to the NPS have fewer choices on asset allocation. Unlike private subscribers who can opt for Active choice with many variations of equity, corporate bonds and government bonds in the NPS, Central employees have only the following three options:

• Active choice: Invest 100% of contributions in G, or government securities
• Auto choice: Invest 100% of contributions in the Conservative Lifecycle Fund (LC25) which caps the maximum equity exposure at 25%
• Auto choice: Invest 100% of contributions in the Moderate Lifecycle Fund (LC50) which caps their equity exposure at 50%

LC25 starts your Equity allocations (E) at 25%, Corporate bond allocations (C ) at 45% and Government bond allocations (G) at 30% if you are below 35 years of age, and reduces E by 1 % each year, and C by 2 % each year while adding to your G every year. By the time you turn 50, this results in just 10% of your corpus being invested in E and 15% in C while 75% is in G.

LC 50 starts off your E allocations at 50% at age 35, with 30% in C and 20% in G. It trims your equity exposure by 2 % and corporate bonds by 1% every year, until at age 50 you are left with 20% in E, 15% in C and 65% in G.

None of these options is great. But between the three, LC50 is a better choice as it improves your chances of earning an inflation-beating return on your retirement fund with a higher equity component.

Ideally, if your retirement is 10 plus years away, over 75-80% of your retirement portfolio should be invested in equities. If you’re a Central government employee therefore, it may be wise to not rely only on the Tier I account for your retirement planning and to have more aggressive equity allocations in Tier II or own equity mutual funds to supplement it. The Active choice with only G is avoidable, as the high-quality corporate bonds in the NPS have the potential to deliver higher returns over the long run that can aid your accumulation.

Do note however that while Central government employees have been offered these Auto choices from April 1 2019, these options are applicable only to their fresh contributions after this date. No process has been devised yet for them to switch their legacy NPS balances accumulated until April 1 2019 to private fund managers or the new auto choice options that they are eligible to pick now. 

Withdrawal and exit

When a Central government employee retires, 40% of the accumulated corpus in the NPS account is used to purchase an annuity while the rest is paid out as lumpsum. If the accumulated sum is less than Rs 2 lakh, the withdrawal can be entirely in lumpsum. In case of premature exit by closing the account before the age of retirement, 80% of the accumulated sum has to be used for annuities with only the rest available as lumpsum. Early VRS by a Central government employee is treated as premature exit with the 80% annuity condition applying.

In case of death of the subscriber during his or her working life, 80% of the corpus is compulsorily used to buy an annuity towards monthly pension for the spouse with only the remaining amount paid to the designated nominee as lumpsum.

Central government employees like other subscribers can however choose to continue with their NPS account until the age 70, deferring either the annuity or lumpsum or both. If interest rates are at rock-bottom at the time of one’s retirement, deferral is an option to consider instead of locking lifelong into poor annuity rates.

In case you do not wish to entirely close your NPS account but only make partial withdrawals from it during your working life, this is subject to the same rules as for private subscribers. Partial withdrawals are capped at 25% of your own accumulated contributions to the scheme. You can make only 3 such withdrawals during your lifetime.

You should have completed at least 3 years with the scheme and must provide proof of the reasons for which you are making the withdrawal. Only withdrawals towards higher education of children, marriage of children, purchase/construction of a residential house, treatment of illnesses, reskilling etc are allowed.

Taxation

Taxation of NPS contributions is slightly different for Central government employees, compared to private sector ones. First, your annual contributions to the NPS are exempt from tax under section 80CCD(1) to the extent 14% of your basic pay plus DA or gross total income whichever is less. Your overall investments in a year are however subject to the 80C limit of Rs 1.5 lakh. However, like private employees, if you have limited room under section 80C you can top up your NPS contributions by upto Rs 50,000 a year to avail of the additional benefit under section 80 CCD(1B).

Two, under section 80CCD(2), the Government’s contributions into your NPS account are tax-free too, to the extent of 14% of your basic pay plus DA. However, if are highly paid you may have to fork out some tax. According to a provision introduced in budget 2020, if your employer’s contribution to all your pension and PF schemes put together exceeds Rs 7.5 lakh a year, both this contribution and the returns on it will be treated as taxable income.

Taxation of your final withdrawal from the NPS is the same as for private subscribers. It is exempt from tax to the extent of 60% of your maturity amount. The remaining 40% is to be compulsorily used to buy an annuity (pension) from approved pension providers. This 40% is not taxed immediately, but the pension amount you receive from the insurer is taxable at your income tax slab rate prevailing at the time of your receiving the pension. Should you close your account and exit NPS prematurely (before 60), 80% will compulsorily be used to buy annuities which will eventually get taxed at your slab rate. You will effectively get tax exemptions only the lumpsum of 20%. Partial withdrawals upto 25% during your working life however are allowed tax-free.

The Tier II account

Central government employees, like private employees can open the NPS Tier II account, which functions as a voluntary market-linked savings vehicle (Read details of how to use the Tier II account here). While the rules for Central government employees opening Tier-II accounts are the same as for private employees, they offer a few extra benefits.

A key one is the flexibility to choose Active choice with the equity component going up to 75%. Central government employees should in fact use the Tier II account to get around the limited Auto choice options offered to them under Tier I.

Tier I can be used mainly for tax benefits with any surplus contributions over and above the tax exempt-portion. Tier II comes with the advantage of anytime liquidity and the flexibility to use your final investment proceeds as you like, without being forced to buy an annuity.

Recently, in a bid to make the account even more attractive to government employees, the CBDT notified new section 80C deductions for Central government employees investing in the NPS Tier II. The notification introduces a new option for Central government employees called the NPS Tier II Tax Saver Scheme 2020. Employees who make contributions to this special account during a year can claim a tax deduction under section 80C of the Income Tax Act (subject to the overall ceiling of Rs 1.5 lakh), with their investments locked in for a minimum period of 3 years. However, if you’re thinking of simply using this account to get around the restrictions of Tier I, do note that this account entails giving up on your flexibility to decide your investment choices under Tier II. This tax saver version of Tier II will mandatorily invest 10-25% in equities and the rest in government and corporate bonds in no fixed proportion.

Given that most folks are likely to have limited room for additional deductions under section 80C anyway, the plain vanilla Tier II account (without tax savings) may be better for your retirement savings with a more favourable asset allocation pattern.

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