NPS Tier 1 vs Tier 2: Difference and Tax Benefits

Financial planning has always been discussed among Indians. The most crucial aspect of one’s financial planning is retirement planning, especially for employed individuals. After retirement, paychecks stop coming, but bills do not. It can get difficult to manage if you don't start planning your retirement. You can opt to invest in various savings schemes for retirement. 

One such beneficial scheme is National Pension System. The government launched NPS in 2004. Here, you will learn what Tier 1 and Tier 2 are in NPS, their differences, tax benefits and more. 

NPS: A brief overview 

Launched in 2004, the National Pension System (NPS) is a government-sponsored pension program. Although it was initially solely available to government workers, the government made it available to everyone in 2009. Individuals can contribute to their NPS accounts while still working and withdraw once they turn 60.

In essence, NPS is an annuity product designed to act as a retirement fund once a person leaves the workforce. 

Tier 1 and Tier 2 NPS accounts are two different categories. As opposed to Tier 1, which serves as the principal NPS account for building a retirement fund, Tier 2 is similar to a voluntary savings account and provides greater flexibility for deposits and withdrawals.

NPS Tier 1 vs NPS Tier 2 

The below table illustrates the differences between NPS tier 1 and tier 2. 

Tax Benefits On NPS Tier 1 And Tier 2 returns 

Tax benefit for salaried employees subscribers of Tier-1 NPS 

• Under Section 80CCE, all NPS Tier 1 subscribers can claim a deduction of up to Rs.1.5 lakhs.
• Employee contributions can be deducted under section 80CCD(1). Still, the total claim deduction under sections 80C to 80CCD(1) cannot be more than Rs. 1,50,000. Rs. 50,000 is also available as a deduction for individual contributions—this Rs. 50,000 is over the limit of section 80CCE.
• Employer contribution is also eligible for deduction under section 80CCD(1B) over the limit of section 80CCE.

Tax benefit for self-employed subscribers of Tier-1 NPS 

• Under Section 80CCE, self-employed  NPS Tier 1 subscribers can claim a deduction of 20% of Gross Total Income, but up to an overall limit of Rs.1.5 lakhs under Section 80CCE.  
• Self-employed persons additionally claim a contribution of Rs. 50,000 under section 80CCD(1B), which is over the limit of section 80CCE.

Tax benefit for self-employed and salaried employees subscribers of Tier-2 NPS.

• Contribution by central government employees who are subscribers of NPS Tier-2 accounts can claim a deduction under section 80C.
• Self-employed, private sector, and state government employees cannot claim a deduction for contributions to Tier-2 NPS under section 80C, which is available only for central government employees.

It is to be noted that deductions under sections 80C, 80CCD(1), and 80CCD(1B) are not available under the new tax regime. Therefore, it is important to understand the difference between the new and old income tax regimes. However, deductions for employer contributions under section 80CCD(2) are available irrespective of the regime.

Tax benefit for mature and premature withdrawal or closure of NPS 

•  Withdrawal and closer of Tier-2 NPS account is much flexible than tier-1 account
• The entire amount invested is tax-free if you purchase an annuity. However, the annuity's income will be taxed at the appropriate rates.
• A maximum of 3 withdrawals are permitted during the entire tenure of NPS. There is a 5-year gap required between each withdrawal.
• You must have been in the National Pension System for at least three years from the date of joining; and
• Withdrawal Before Retirement- A Maximum withdrawal of 25% of your contributions is permitted. If your employer has also made contributions to your NPS account, note that only 25% of your contributions can be withdrawn.
• Withdrawal On or After Retirement- Maximum withdrawal of 60% of the NPS corpus as a lump sum on attaining the age of 60 Years permitted. 40% should be utilised to purchase an annuity plan.

NPS Tier 1 Vs NPS Tier 2 – Which One Should You Choose? 

Under Section 80CCD (1), Tier 1 investors may receive a tax exemption for an additional investment of up to Rs.50,000. Premature withdrawals and the purchase of annuities both qualify for deductions. 

There are no tax advantages for Tier 2 accounts. Your ability to decrease your yearly taxes is significantly reduced as a result. 

There are fewer options for withdrawals before maturity in Tier 1 accounts because they are significantly more restricted.

Tier 2 subscribers can make an early withdrawal to cover different expenses. Hence, Tier 2 subscribers can better manage all financial needs with the collected funds.

Both Tier 1 and 2 have advantages and disadvantages. So, one must choose one after giving it great thought.

Conclusion 

While most investments are made in Tier 1 or Tier 2 accounts, keeping both investments active is feasible. Hence, a new investor can open a Tier 1 and Tier 2 account simultaneously.