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NPS vs ELSS: Which one to prefer for tax savings?

Created on 23 Dec 2020

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Updated on 10 Sep 2022

How can I save tax? Is there an investment scheme that can help me save some tax money?

This is a question always asked by the taxpayer when they are looking to save taxes and invest for future returns as well. When one is planning for his taxes, one may choose to invest in a variety of investment options to save tax. 

Section 80C of the Income Tax Act, 1961 provides numerous options for the taxpayers to lower the tax liability; two of which are most famous, namely Equity Linked Saving Scheme and the National Pension Scheme. Not only do they save taxes, but they also provide wealth benefits through the power of compounding and exposure to the equities. 

Most people look up to these schemes during the last quarter of the financial year, then they consult with an investment agent or a tax planner and choose the schemes in a hurry without even understanding them. 

As a result, they mostly end up parking their money in schemes which do not meet their long-term financial goal. Hence, it becomes important to understand both NPS and ELSS in order to choose the one which can better suit your personal financial goals.

Let’s try to understand these two schemes and find out which one is better for you.

What is the National Pension Scheme (NPS)?

The National Pension Scheme (or the NPS) is a government-sponsored scheme, specially formulated for retirement savings. It allows employees and self-employed persons to invest in it and claim a tax deduction up to Rs 1,50,000 under Section 80CCD (1). NPS also qualifies for additional tax savings of Rs 50,000 under Section 80CCD (1B). 

Under the NPS framework, the NPS professionals invest NPS funds into a well-diversified portfolio which is a combination of Government Bonds, Corporate Debentures and Equity shares. After the investment in NPS, investors are eligible to open two kinds of accounts, namely Tier 1 and Tier 2 NPS accounts. One can open a Tier 2 account only if one has a Tier 1 account.

However, investors can withdraw from NPS only at the time of retirement at the age of 60. Withdrawals before that are discouraged: one can withdraw only 20 per cent of the aggregate, and the rest of the money should be compulsorily used to buy an annuity.

What is an Equity Linked Saving System (ELSS)?

An Equity Linked Saving System (ELSS) is an open-ended mutual fund where one can invest a lump sum amount or make a regular investment through SIP for investment in the equity market. It comes with a tax benefit up to Rs 1,50,000 under Section 80C.

Most people enter the stock market universe through ELSS. This scheme has a lock-in period of three years, which means you cannot sell your investment for three years. In the case of ELSS SIP investment, each instalment is locked in for a three-year tenure.

ELSS is popular among those who are ready to take a risk for a large return. The dividends are tax-free at the hands of investors. Long term capital gains from the ELSS above Rs 1 lakh is subject to tax at the rate of 10% of the gains made. 

So obviously, NPS provides tax deductions up to Rs 2,00,000, while ELSS provides tax deductions up to Rs 1,50,000. 

But, that is not the sole reason for the comparison. In order to select the best-suited scheme from among the two, there are a few other parameters that should be considered.

Comparison between ELSS and NPS

Let’s draw a comparison between NPS and ELSS to help understand how both the schemes are different from each other and figure out which one would be better suited for your financial needs based on the following parameters:

Tax Benefit

Investment in ELSS is one of the available investment options under Section 80C, and the investors may avail of a maximum tax benefit up to Rs. 1.50 lakh for investing in ELSS. Nevertheless, this tax benefit is to be observed in coexistence with the other tax-saving investments done by the taxpayer, including repayment of home loan, payment of life insurance premium, etc. 

On the contrary, contribution to the NPS account is eligible under Section 80CCD, as well as Section 80CCD (1B) of the Income Tax Act. So, one can get an aggregate tax deduction of Rs. 2.00 lakhs by investing in NPS, inclusive of the additional Rs. 50,000 tax deduction which is available for a voluntary contribution to the NPS account. Also, it is the only eligible investment option for an additional Rs. 50,000 tax benefit. 

Lock-in Period

The investments in ELSS have a lock-in period of 3 years from the time of investment made. On the contrary, the fund value under the Tier-1 account of NPS cannot be fully withdrawn before the age of 60, even though the fund can be withdrawn partially for certain specific reasons.

As such, a short lock-in period of only three years makes ELSS a preferred choice of investment for the investors. 

Asset Allocation

Both ELSS, as well as NPS, allow the investor to generate market-based returns. While the portfolio of ELSS might predominantly be equity-oriented (at least 80%), the allocation of the NPS portfolio under equities, Govt. bonds, and Corporate bonds may be described personally by the investor. 

NPS accounts allow the investor to decide manual asset allocation or automatic asset allocation. The auto asset allocation strategy constantly shifts to the debt portfolio as the ageing surge. 

Liquidity

The NPS offers comparatively fewer liquidity, and there could be situations where you can face numerous restrictions regarding exit, the amount received on withdrawal, and its utilisation thereafter. When you exit the scheme at the age of 60, you receive only 60% of the fund value in a lump sum amount. You need to purchase an annuity with the remaining balance of 40% of the aggregate. You will receive the full corpus on retirement only when your fund value is less than 2 lakh rupees. You are allowed to exit before attaining 60 years only on certain occasions such as your children’s marriage, etc. In such a case, you will be forced to annuities 80% of your retirement corpus.

ELSS funds are much more liquid in nature as compared to the NPS. You are free to exit the fund any time after the lock-in period of 3 years is finished. Yet, to obtain the full benefits, one should stay invested for at least 5 years or more.

Taxation of Returns

Under the ELSS scheme, investors are liable to pay tax at a flat rate of 10% (also with applicable cess and surcharge) on the long-term capital gains, which is the net appreciation from ELSS investment. Furthermore, the taxpayer is eligible for an aggregate exemption of Rs. 1 lakh in respect of long-term capital gains from equity shares and equity-oriented mutual funds in aggregate during the year. 

On the contrary, the investors under NPS may withdraw a portfolio corpus of up to 60% at the time of retirement, which will be tax-free. Moreover, the investors must purchase an annuity for the balance 40% and the annuity so received will be taxable in the year of receipt.

Conclusion

It is advisable to always get yourself a proper financial plan made. Tax planning is an integral part of the financial plan of every individual. Just investing some amount here and there won’t always fulfil all your financial needs and goals. 

Hence, in order to make the most of your investments, it is necessary to judiciously analyse all investment options, and do proper tax planning before putting in your money anywhere.

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Pratiksha Mahawar

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Sugar, spice & everything nice, that's what Pratiksha is made of. This proactive human, who is also a PhD scholar, makes difficult things look easy through her amazing skill of managing everything, be it professional or academic. Let’s not forget how this “Potterhead” makes room for her ‘occasional writing’ hobby while she leads marketing activities at Finology. 

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