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Difference between NPS Tier 1 and Tier 2

Difference between NPS Tier 1 and Tier 2

Today, when Indians increasingly fall under the pressure of rising inflation and the cost of living crisis, financial planning has become necessary. For these reasons alone, working professionals must plan long-term — towards a pension programme that’s rewarding in multiple ways.

The Indian government, fortunately, has been working towards that cause for the last two decades. Having discontinued the Old Pension Scheme (OPS) in 2004, the Centre introduced the National Pension System (NPS), a programme that doubles as a tax-saving investment option.

To know how you can benefit from the NPS scheme, it’s essential that you understand a few basics — complex terms like NPS Tier 1 and Tier 2

Who Can Apply for NPS?

Initially available only to government employees, NPS was made accessible to all Indians, including NRIs, in 2009. Any working individual between 18 and 70 years of age can open an NPS account and start contributing to their corpus.

Subscribers, though, will be categorised under any of the three models of the NPS.

  • All Citizens of India: This category includes all working individuals within the aforementioned age bracket. NRIs can open an NPS account as well.
  • Corporate NPS: All employers and corporates (in the organised sector) who wish to contribute to their employees’ pensions come under this category.
  • Central or State Government: All government employees, who joined on or after 1st January 2004, are mandated to open an NPS account and fall under this category.

The Two Types of Accounts

To provide subscribers with a host of attractive investment options, NPS offers two kinds of retirement accounts — NPS Tier 1 and Tier 2. While the former is the more standardised account for retirement planning, the latter offers more flexibility for deposits and withdrawals.

NPS Tier 1 Account

  • Lock-in Period: Any subscriber opting for an NPS Tier 1 account must deposit ₹500 as the initial investment. Thereon, you can keep contributing to your corpus pool by depositing a minimum of ₹1,000 per year. An important aspect of this account is that the subscribers cannot withdraw funds till superannuation, i.e., a lock-in period till one turns 60. However, this requirement can be dissolved in exceptional circumstances, such as the account holder’s death or medical emergencies. Called partial withdrawals, a subscriber can remove 25 per cent of the total amount with tax exemptions. 
  • Corpus Demarcation: Once a subscriber reaches the age of 60 and the amount matures, they can withdraw 60 per cent of the total amount tax-free. The rest 40 per cent is used to purchase annuity plans for monthly pension purposes. 
  • Tax Exemption Benefits: NPS Tier 1 accounts also offer lucrative tax-exemption benefits in the form of the Exempt-Exempt-Exempt model. The first Exempt is related to individual contributions. Subscribers can claim tax benefits under Section 80 CCD(1) of the Income Tax Act 1961, within the overall ceiling of ₹1.5 Lakhs under Section 80 CCE. They can also benefit from an additional tax deduction of ₹50,000 under Section 80 CCD (1 B). 

The second Exempt becomes functional when contributions earn rewards without tax deductions. And the third Exempt is where the subscriber withdraws 60 per cent of the amount upon maturity tax-free.

NPS Tier 2 Account

An NPS Tier 2 account shows variations from an NPS Tier 1 account.

  • No Lock-in Period: Any Indian with an active Tier 1 account can open a Tier 2 account, and the minimum amount to start investing is ₹1,000.  A voluntary savings account offering easy liquidity, it has no lock-in period. A subscriber can withdraw funds at any point in time. Moreover, they can do it in a lump sum or choose multiple withdrawals.
  • Tax Exemption Benefits: On the aspect of tax exemptions, an NPS Tier 2 account doesn’t offer many benefits. Contributions under this account aren’t tax exempted, except for government employees. For them, contributions are eligible for deductions under Section 80C of the Income Tax Act. However, even government employees must bear a lock-in period of three years, and the minimum contribution amount is ₹250.

Should You Choose a Tier 1 or Tier 2 Account?

No matter which NPS account you opt for, you can’t withdraw the entire corpus upon superannuation. The 40 per cent amount is necessary to receive a regular pension from an annuity service provider. This is regulated by the Pension Fund Regulatory and Development Authority (PFRDA). After all, a lifelong pension programme that takes care of all your needs is the fundamental goal of both NPS Tier 1 and Tier 2 accounts. 

So, which account should you choose? The answer can depend on factors such as tax exemption and active investment concerns — for which NPS Tier 1 looks more viable. Partial and lump sum withdrawals are tax-free with a Tier 1 account.

If you prioritise greater withdrawal freedom, you can opt for a Tier 2 account, though with decreased tax benefits. You can even cover your early expenses with premature withdrawals at any point in time. Ultimately, the answer depends on what your priorities are and how good your financial planning is. 

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