what is Mutual Funds?

A few weeks ago, I had said in a column on mutual fund taxation that National Pension Scheme (NPS) Tier-2 could be thought of as a low-cost mutual fund. But that was not accurate. Though Tier-2 funds are withdrawable like mutual funds, they are not taxed like mutual funds. There is no specific mention of Tier-2 in the tax code. So, by default, they fall under the general category of 'income from other sources' and your income is taxed at the applicable rate. Thus, you do not have the tax benefits that mutual funds have. In Tier-2, the money keeps accumulating till you redeem it. Thus, it plays a role in enhancing the benefits.

You can do to enhance pension

For government employees, Tier-2 is available as one of the acceptable 80C tax saving options with a lock-in of three years. However, it is difficult to see whether anyone will use it. This means that instead of considering Tier-2 as an alternative to mutual funds, it is considered as an additional contribution to your pension. You can accumulate it and eventually use it to enhance your pension. I don't know how many people have done this, but the asset class is best designed to be used this way. Or, if you need the money at some point, you can withdraw. As most NPS members know, or should know, Tier-1 money is not completely liquid and is available for withdrawal. But only partially and for certain purposes.

Tier-2 to Tier-1 switch possible

An interesting thing about NPS is that it can be a one-way switch from Tier-2 to Tier-1. This way, at the time of retirement (or whenever you exit NPS till age 70), the money deposited in Tier-2 can be treated the same as exiting NPS after retirement. That is, 60 per cent of the withdrawn amount is tax-free. So, if you can withdraw 60 per cent of the NPS corpus at once and use the remaining 40 per cent for annuity, then no tax will have to be paid at that time. Only in subsequent years the annuity income will be taxed as per the slab.