Mutual Funds or NPS Tier 2: Which one is better for you?

There are several market-linked investment options available today. Two well-known ones are mutual Funds and NPS Tier 2. While both instruments have their benefits and drawbacks. Therefore, it is important for an investor to determine which is more suitable for their unique situation.

In this article, we will help you understand NPS Tier 2 vs Mutual Fund more clearly. Let us discuss the differences between these two investment options so you can figure out which one suits your financial goals more.

• Table of contents

• Understanding NPS Tier 2
• Understanding mutual funds
• Differences between NPS Tier 2 and mutual funds
• NPS Tier 2 or mutual funds: Which is more suitable?
• Who should invest in NPS Tier 2 over mutual funds?
• Who should invest in mutual funds over NPS Tier 2?

Understanding NPS Tier 2

National Pension System (NPS) is a government-sponsored retirement savings scheme that is managed by Pension Fund Regulatory and Development Authority (PFRDA). Under NPS, there are two investment options that can help you potentially build a corpus fund over time. These are:

• NPS Tier 1: The primary retirement account with a mandatory lock-in until the age of 60.
• NPS Tier 2: An optional account. It gives more flexibility and doesn’t come with the same lock-in conditions.

Key features of NPS Tier 2:

• You can open a Tier 2 account only if you already have a Tier 1 account and a PRAN number.
• There’s no lock-in period. You can invest and withdraw any time.
• It doesn’t offer tax benefits.
• The investment in Tier 2 is managed by professional fund managers.
• You can choose between different asset classes like equity, corporate bonds, and government securities. However, options are limited compared to mutual funds.

Understanding mutual funds

A mutual fund is an investment vehicle where money from various individuals is pooled together and invested in different instruments like stocks, bonds and other securities. The fund is managed by a professional fund manager who aims to potentially grow your money over time while mitigating risk.

Key features of mutual funds:

• Wide variety of schemes: Mutual Funds offer vast variety like equity funds, debt funds, hybrid funds, index funds and more.
• Flexibility to invest in SIPs: You can invest in mutual funds via SIP (Systematic Investment Plan) or lumpsum.
• Liquidity: Most open-ended funds allow you to withdraw your money when you need it (except in funds like ELSS, which have a lock-in period).
• Regulated by SEBI: Since mutual funds are regulated by SEBI, their functioning is transparent and investor-friendly.
• Suitable for many kinds of investors: Whether you are conservative or aggressive, mutual funds have options for a wide range of investors.

Differences between NPS Tier 2 and mutual funds

Purpose of investment

• NPS Tier 2: Designed as an extension of the NPS retirement plan. However, it has more flexibility than NPS tier -1, with no lock-in period and the option to invest up to 100% in equities. This makes it more growth-oriented than the tier 1 account, which caps equity investments at 75%. Investors can also choose to allocate some part of their investments generate a pension in the form of annuities.
• Mutual funds: Can be used for any financial goal be it short-term, medium-term or long-term. There is no pension or annuity option, but investors can choose a Systematic Withdrawal Plan to withdraw money from their corpus in regular instalments.

Regulated by

• NPS Tier 2: This is regulated by PFRDA.
• Mutual funds: This is regulated by SEBI.

Tax benefits

• NPS Tier 2: No tax benefits for private sector employees.
• Mutual Funds: ELSS (Equity Linked Saving Schemes) offer tax deduction of up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, 1961, under the old regime.

Lock-in period

• NPS Tier 2: No lock-in period. You can redeem anytime.
• Mutual Funds: Most are open-ended with no lock-in. ELSS funds come with a 3-year lock-in.

Returns (no guarantee of returns with either option)

• NPS Tier 2: The return potential depends upon the asset class chosen and market conditions. Aggressive investors can choose to invest up to 100% in equities, while investors seeking lower risk can opt for corporate or government debt instruments.
• Mutual funds: Potential returns vary widely depending on the type of fund and market conditions. Equity funds can help build wealth in the long term, while debt or hybrid funds may offer relative stability along with reasonable return potential.

Cost and charges

• NPS Tier 2: Relatively lower cost structure.
• Mutual Funds: Expense ratios vary from company to company. Additionally, actively managed funds may have higher charges, while passive funds have lower costs.

Ease of access and exit

• NPS Tier 2: Requires Tier 1 account, making it less accessible than mutual funds. Doesn’t require a minimum balance and funds can be withdrawn at any time without any exit fee.
• Mutual funds: Easily available on multiple platforms, apps, and through advisors. May charge an exit load if you exit the fund before a certain period.

Read Also: Mutual Funds Vs. Stocks and Bonds: Understanding the Difference

NPS Tier 2 or mutual funds: Which is more suitable?

Both are comparable investment options and their risk level depends upon the equity allocation. Between the two, mutual funds may suit those who want flexibility, wider options and access to different investment themes and strategies. Also, mutual funds may be more accessible to those who do not have an existing NPS Tier 1 account.

It also depends on the purpose of your investment. If creating a corpus for your retirement is your objective, Tier 1 may have more advantages in terms of tax benefits and annuities.

Who should invest in NPS Tier 2 over mutual funds?

• Central government employees: Central government employees get tax exemption of investments of up to Rs. 1,50,000 under Section 80C of the Income Tax Act, 1961 (old regime), under the Tax Saver NPS Tier 2 option. However, there is a lock-in period of three years for this type of account.
• Existing NPS Tier 1 holders: Since Tier 2 is only available with a Tier 1 account, it’s an option for those already in the NPS system.
• Investors seeking a lower cost option: The management fee for NPS accounts is typically lower than that of mutual funds.

Read Also: ETF vs Mutual Fund: Meaning, Types, Key Differences and Investment Tips

Who should invest in mutual funds over NPS Tier 2?

• No NPS Tier 1 account: If you don’t have NPS Tier 1 account. Since Tier 2 requires it, Mutual Funds are more accessible.
• Customisation of portfolio: With access to different market caps, sectors and investing styles, mutual funds can offer more investment options than NPS.
• SIP-based investing: Mutual Funds support regular investing through Systematic Investment Plans. Investors can choose various frequencies such as daily, weekly, monthly, quarterly etc. This can help in disciplined saving.

Conclusion

While both NPS Tier 2 and mutual funds have their own advantages, they are designed for different types of investors. The choice between the two depends upon an investor’s goals, priorities and investment preferences.

FAQs:

Is NPS Tier 2 better than mutual funds?

It depends on your needs. NPS Tier 2 may be suitable for low-cost investments with a more hands off approach. Mutual funds are more suitable for those seeking more choice in terms of fund categories and asset allocation.

What is the disadvantage of NPS Tier 2?

Unlike NPS tier 1, tier 2 does not offer tax benefits (except for central government employees). Also, you need a Tier 1 account to invest, and fund options are limited.

Can I invest only in Tier 2 NPS?

No. You need to have an active Tier 1 account first. Only then can you open a Tier 2 account.

What is the return rate for NPS Tier 2?

The return rate depends upon the equity allocation. NPS Tier 2 investors can choose to allocate up to 100% in equities, which can offer inflation-beating growth potential in the long-term.

What is the lock-in period for NPS Tier 2?

There is no lock-in period for Tier 2. You can withdraw your money anytime, unlike Tier 1, which has a mandatory lock-in until retirement, with premature withdrawal of up to 20% of the corpus allowed after five years. Partial withdrawal is also permitted after three years for specific reasons such as illness, disability, education of the investor’s children and some other conditions.

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