NPS Tier 1 vs Tier 2: Differences, Tax Benefits, Which is Better?
The National Pension Scheme (NPS) is a government-backed pension and investment plan launched in 2004. Initially, it was intended for government employees, but in 2009, NPS was expanded to cover employees from the private sector. The initiative is to provide financial and social security to senior citizens. NPS, regulated by the Pension Fund Regulatory and Development Authority (PFRDA), offers attractive long-term savings options to help you prepare for retirement.
Any Indian citizen between the ages of 18 years to 70 years is eligible for this pension scheme. The purpose is to encourage citizens to invest in a pension account throughout their employment. After retirement, contributors can withdraw part of their retirement savings as lumpsum and receive the remaining monthly pension.
NPS also offers excellent tax advantages under Section 80 CCD(1). Employees can claim tax education of up to 10% of their salary (basic + DA), and those self-employed can claim up to 20% of their gross income. Although, as per section 80C, the maximum tax exemption limit is Rs. 1.5 lakh, NPS offers additional tax benefits of Rs. 50,000 under Section 80CCD(1B).
There are two types of NPS accounts: Tier 1 and Tier 2. Learn the difference between NPS Tier 1 and Tier 2 accounts, their features, tax benefits, and more. Further, you’ll know which is better for you.
What are NPS Tier 1 and Tier 2 Accounts?
NPS Tier 1 is a primary NPS account that opens by default when opting to invest in an NPS scheme. It is mandatory to open Tier 1 for those who register under NPS. It is meant for retirement savings with a minimum contribution of ₹500 for opening the account. Under a Tier 1 account, you can withdraw 60% of the accumulated corpus tax-free at retirement. You need to buy the annuities with the remaining 40% of the corpus that ensures a secure regular monthly income through a pension. This pension is taxable as per the individual tax slabs. A minimum investment of ₹1,000 in this account is mandatory in a financial year.
To open an NPS Tier 2 account, having an NPS Tier 1 account is mandatory. This voluntary account requires a minimum contribution of ₹1,000 at opening. There is no requirement for compulsory annual contributions for Tier 2 account holders. However, any contribution to this account must be multiples of ₹250. There is no set limit for maximum contribution. It allows the investor with greater withdrawal flexibility with no exit charges. The amount contributed to this account gets invested into different funds. It benefits those who want to contribute more to their existing NPS account. The withdrawal process generally takes three days.
Difference Between NPS Tier 1 and Tier 2 Account
An NPS Tier 1 account is mandatory for investing in the NPS plan. You must have a Tier 1 NPS account to begin contributing to NPS. You cannot open a Tier 2 account without holding a Tier 1 account. Tier 1 NPS account is primarily for retirement savings. It requires a minimum contribution of ₹500 to open the account. On the other hand, you have to make a minimum contribution of ₹1,000 to open an NPS Tier 2 account.
The primary difference between Tier 1 and Tier 2 NPS is the withdrawal restrictions and limits. Withdrawal is limited and conditional in Tier 1, while in Tier 2, withdrawal is flexible.
You can open an NPS Tier 2 account while opening your primary Tier 1 account. Or, you can activate it later on through the eNPS website or offline by visiting your nearest Point of Presence (POP) centre. A POP centre can be a bank or any financial institution appointed by PFRDA.
In terms of structure, NPS Tier 1 and Tier 2 are similar. The options for selecting pension fund managers (PFM) and asset classes, i.e., corporate bonds, government bonds, equity, and alternative assets, are the same.
9 Differences Between NPS Tier 1 and Tier 2
|Basis||NPS Tier 1||NPS Tier 2|
|Eligibility||Any Indian citizen between the age of 18 and 65 years can open a Tier 1 account||Any Indian citizen with an active Tier 1 account is eligible to opt-in for the Tier 2 account|
|Lock-in period||Investments made in Tier 1 of NPS are locked in till you are 60 years old.||No lock-in period|
|Withdrawal limit||Upon reaching 60 years of age, you can withdraw up to 60% of your corpus. The remaining 40% will be used to acquire annuities to provide you with a fixed income.||It is possible to withdraw the accumulated funds fully or partially. You can use it like a regular savings account.|
|Voluntary exit||You can voluntarily exit from NPS if you have held the account for at least ten years or more.|
If your total corpus is less than or equal to ₹5 lakh, you can withdraw all of your fundsIf your total corpus is more than ₹2.5 lakh, at least 80% of the accumulated corpus will have to be utilised for the purchase of an annuity, and the remaining 20% will be paid as a lump sum
|You can withdraw from the NPS Tier 2 account at any time, as there is no lock-in period. However, if you are a central government employee, you must hold your NPS account for at least three years to qualify for tax deductions.|
|Minimum annual contributions||₹ 500||₹ 1,000|
|Tax benefit||Employees can claim up to 10% of their salary as tax exemption under Section 80 CCD(1). Self-employed individuals can claim up to 20% of their gross income. However, as per Section 80C, the maximum tax exemption limit is Rs 1.5 lakh.|
NPS also offers an additional tax benefit of Rs. 50,000 under Section 80CCD(1B).
|Only central government employees are eligible for tax breaks up to Rs. 1.5 lakh under Section 80C with Tier II NPS accounts when they hold it for three years or more|
|Taxation on Withdrawal||You can withdraw up to 60% of your balance tax-free upon maturity. The remaining 40% invested in an annuity is also tax-free. However, the annuity income is taxable according to your income tax slab.||It is added to your income and taxable according to your tax slab.|
|Fund transfers||You can transfer Tier 2 and EPF funds to your Tier 1 account||Fund transfers are not allowed|
Claiming Tax Benefits on NPS Tier 1 & Tier 2 Returns
- Contributing to NPS Tier 1 allows employees to claim up to 10% of their salary (Basic + DA) as tax exemption under Section 80 CCD(1). Self-employed individuals can claim up to 20% of their gross income.
- However, as per Section 80C, the maximum tax exemption limit is Rs. 1.5 lakh (this Rs. 1.5 lakh is in addition to the 10% of basic plus DA which the employer can deduct from salary and deposit directly in NPS account of the employee). NPS Tier 1 also offers additional tax benefits of Rs. 50,000 under Section 80CCD(1B).
- Contributing to an NPS Tier 2 account offers central government employees a tax break of up to 1.5 lakh rupees under Section 80C when they hold it for three years or more. (Private sector employees or self-employed professionals are not eligible for tax exemption.)
- You can withdraw up to 60% of your NPS Tier 1 account tax-free upon maturity. The remaining 40% invested in an annuity is also tax-free. However, the annuity income is taxable according to your income tax slab.
- You can partially withdraw up to 25% of your contribution to the corpus tax-free from the NPS Tier 1 account in certain situations. You may withdraw partially for medical emergencies, construction or purchase of a house, children’s higher education, and children’s marriage. Partial withdrawals are allowed only after holding your account for at least three years.
NPS Tier 1 vs. Tier 2: Which is Better?
The following factors must be considered before choosing the National Pension Scheme:
- Retirement Planning: If your goal is to save for your retirement, NPS tier 1 suits you well. There is a mandatory lock-in until you turn 60, which ensures that your retirement portfolio is not harmed in any manner.
- Tax Saving: Under Tier 1, investors receive an additional deduction of up to ₹ 50,000 under section 80CCD (1). Premature withdrawals and the purchase of annuities both qualify for deductions. However, no exemptions are allowed for investment in tier 2.
- Short-term investment: If you want to invest in the short term, tier 2 NPS is best for you as there is no lock-in period, and you can withdraw your investment easily.
- Flexibility of Investment: Tier 2 is more flexible in terms of investment, as there is no restriction on equity investment. However, in tier 1 NPS, there is a maximum limit of 50% investment in equities.
NPS Tier 1 and 2 accounts have similar structures but differ significantly in terms of their withdrawal rules and tax exemptions offered. An NPS Tier 1 account is mandatory to start investing in the NPS scheme. You could consider investing in Tier 1 or both NPS Tier 1 and Tier 2 accounts based on your financial goals. Before making a decision, consider factors such as returns, retirement savings, and withdrawal flexibility.
FAQs about Tier 1 and Tier 2 NPS
Is Tier 1 NPS taxable?
Contributions to NPS Tier 1 are eligible for tax deductions up to Rs. 1.5 lakh under Section 80 C and an additional Rs. 50,000 under Section 80 CCD (1B).
Upon maturity, you can withdraw up to 60% of your NPS Tier 1 corpus tax-free. The remaining 40% invested in an annuity is also tax-free.
What is the NPS lock-in period?
The NPS Tier 1 lock-in period is until the subscriber reaches 60 years of age. Accounts on Tier 2 do not have a lock-in period. It is therefore possible to withdraw funds at any time.
What is the difference between NPS Tier 1 and Tier 2?
The NPS Tier 1 and Tier 2 differ significantly in their withdrawal restrictions and tax exemptions. An NPS Tier 1 account can help you accumulate sufficient funds for retirement. A Tier 2 account can allow you to save for short-term financial goals and obligations.
Are there any options for fund managers in NPS?
Here are eight NPS pension fund managers who manage the investments of NPS subscribers:
1. Aditya Birla Sun Life Pension Management Limited
2. HDFC Pension Management Company Limited
3. UTI Retirement Solutions Limited
4. SBI Pension Funds Private Limited
5. ICICI Prudential Pension Funds Management Company Limited
6. Reliance Pension Fund
7. Kotak Mahindra Pension Fund Limited
8. LIC Pension Fund
What is the minimum contribution for opening an NPS account?
You will need to make a minimum initial contribution of ₹ 500 to open a Tier 1 NPS account. For a Tier 2 account, it is mandatory to make an initial contribution of ₹ 1,000.
Can I convert my NPS Tier 1 account to a Tier 2 account?
No, you cannot convert your NPS Tier 1 account to Tier 2. However, there is an option of transferring your funds from a tier 2 account to tier 1. This is called a “one-way switch”