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NPS vs ELSS: Differences and which is more suitable?

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National Pension System (NPS) and Equity-Linked Savings Schemes (ELSS) are two popular investment options offering tax-saving benefits in India. Both offer unique advantages based on individual financial goals and risk tolerance, making them suitable for different types of investors.

This article tells you more about the meaning of NPS and ELSS and break down the differences between NPS vs ELSS so that you can identify a suitable investment option for you.

  • Table of contents
  1. NPS and ELSS: Overview
  2. Key features of national pension system (NPS)
  3. Key features of equity-linked savings scheme (ELSS)
  4. Tax benefits on NPS
  5. Tax benefits on ELSS
  6. Who should invest in NPS?
  7. Who should consider ELSS?
  8. NPS vs ELSS: Key differences between the National Pension System (NPS) and Equity-Linked Savings Schemes
  9. NPS vs ELSS: How does the performance of NPS and ELSS compare over the years?
  10. ELSS vs. NPS: Which approach is more suitable?
  11. NPS vs ELSS: Key points to remember

NPS and ELSS: Overview

The NPS full form is National Pension System. It is a government-backed retirement savings scheme that offers tax benefits through investments in market-linked instruments such as equity (maximum of 75% of the portfolio), corporate bonds, government securities and alternative investment funds such as REITS and InvITs for long-term wealth accumulation potential. It also has a pension element – a part of the invested amount is used to finance an annuity plan.

Investors can choose how to spread out their investments across these asset classes based on the number of years till retirement and risk appetite. NPS investments offer several tax benefits, on the principal as well as withdrawn amount.

ELSS, short for Equity Linked Savings Scheme, is an equity mutual fund that primarily invests in equities. Mutual funds are pooled investment vehicles where money invested by individual investors is pooled together and invested in a basket of securities. These securities could include equities, bonds, commodities etc.

ELSS funds can have a higher equity allocation than NPS, because the latter’s equity portion can comprise a maximum of 75% of the portfolio. As a result, it provides the potential for better returns in the long-term but comes with a more risk. Tax benefits for investments made in ELSS schemes can be claimed under Section 80C of the old regime of the Income Tax Act, 1961.

Key features of national pension system (NPS)

  • Retirement focus: NPS is primarily a retirement-oriented investment avenue and is therefore more conservative than pure equity investments. Also, a bulk of the corpus is illiquid till the investor reaches retirement age.
  • Two types of accounts: In Tier I account, the investor contributions are locked until retirement, with limited partial withdrawals allowed under specific circumstances. Tier II is a voluntary savings account that allows withdrawals before retirement. However, the Tier II account does not offer tax benefits.
  • Portability: It offers portability across jobs.
  • Mandatory annuity purchase: A portion of the NPS corpus must be used at the time of retirement to buy an annuity for pension income.
  • Limited liquidity: NPS encourages staying invested until requirement. However, partial withdrawal of up to 25% of the corpus is allowed after three years for specific reasons such as medical reasons, education or marriage of children, purchasing a property and starting a venture.

Key features of equity-linked savings scheme (ELSS)

  • More liquidity: An Equity-linked Savings Scheme comes with a 3-year lock-in period, which is one of the shortest lock-in periods among tax-saving instruments. Post this, investors can redeem all their funds or stay invested, as per their requirements and preferences.
  • Better long-term return potential: Since ELSS schemes invest primarily in equities they offer a higher growth potential. However, on the flip side, they also come with a higher level of risk.
  • Multiple investment options: Investors can choose to invest a lump sum into an ELSS or start SIP investments. This flexibility makes them a favourite among most investors.
  • Combines growth potential with tax savings: ELSS offers tax benefits as well as the potential to build wealth over time. With a three-year lock in period, it can be suitable for very long term goals such as retirement as well as more near-term ones such as a home purchase, higher education, wedding planning and more.

Tax benefits on NPS

NPS offers several tax benefits under the old regime of the Income Tax Act, 1961. These are as follows:

  • Contributions made by individuals are eligible for a deduction of up to Rs. 1.5 lakh under Section 80CCD(1), within the overall Rs. 1.5 lakh limit of Section 80CCE.
  • An additional exclusive deduction of Rs. 50,000 is available under Section 80CCD(1B), making the total deductible contribution Rs. 2 lakh annually with NPS.
  • Employers' contributions to NPS, up to 10% of basic salary plus dearness allowance, are deductible under Section 80CCD(2).
  • At retirement, up to 60% of the accumulated corpus is tax-free, while 40% used for annuity is fully tax-exempt.

Tax benefits on ELSS

Investments up to Rs. 1.5 lakh annually in ELSS are eligible for deduction under Section 80C of the old regime of the Income Tax, reducing taxable income. Returns from ELSS are treated as Long-Term Capital Gains (LTCG) and are tax-free up to Rs. 1.25 lakh annually. Gains exceeding Rs. 1.25 lakh are taxed at 12.5% upon withdrawal.

Who should invest in NPS?

You should consider investing in the National Pension System if:

  • You are a salaried employee or self-employed professional who wants to secure a pension after retirement.
  • You are comfortable with market-linked investments but want to diversify across equities and relatively stable options like government bonds.
  • You are a high-income investor who wants to avail tax benefits beyond the 80C limit.

Who should consider ELSS?

Now that you know the ELSS meaning, let’s look at who should consider investing in Equity-linked Savings Schemes. You may find this fund suitable if:

  • You are a growth-oriented investor who can handle market ups and downs.
  • You have an investment horizon of at least 3 years.
  • You are a young investor who has many working years ahead of you.
  • You seek tax benefits under Section 80C but do not want a lengthy lock-in period.

NPS vs ELSS: Key differences between the National Pension System (NPS) and Equity-Linked Savings Schemes

  • Objective: NPS is primarily a retirement savings scheme that aims to provide a steady income post-retirement. In contrast, an Equity-Linked Savings Scheme is a tax-saving mutual fund focused on long-term wealth creation through equity investments.
  • Tax benefits: Both NPS and ELSS offer tax benefits under Section 80CCE. However, NPS also offers an additional deduction of up to Rs. 50,000 under Section 80CCD(1B) and on a significant portion of the withdrawal amount.
  • Lock-in period: NPS has a mandatory lock-in until retirement, with partial withdrawals allowed under limited circumstances after three years. ELSS has a 3-year lock-in period, with no restrictions thereon.
  • Risk and return potential: NPS invests in a mix of equity, government securities, and corporate bonds. The equity component depends upon the portfolio type chosen by the investor but cannot exceed 75%. Thus, NPS investments may have slightly lower risk and return potential than mutual funds. ELSS is more equity-centric which means that it comes with a potential for better long-term returns at a higher level of risk.

NPS vs ELSS: How does the performance of NPS and ELSS compare over the years?

The performance of NPS and ELSS varies greatly based on their asset allocation. NPS generally offers the potential for steady and reasonable returns due to its diversified investments in equity, government securities, and corporate bonds. However, the returns depend upon the asset class mix. Some investors may opt for an equity-oriented portfolio while others may lean more towards bonds. Under the auto choice – where the portfolio mix is predetermined – the equity exposure reduces as the investor ages.

In contrast, ELSS is typically equity-oriented and therefore has the potential to deliver better returns over the long term but with higher volatility. Over the years, ELSS has outperformed* NPS in terms of growth, particularly during bullish market periods. *Past performance may or may not be sustained in the future.

ELSS vs. NPS: Which approach is more suitable?

ELSS is more suitable for investors seeking better long-term returns through equity exposure with a 3-year lock-in and tax benefits. It suits aggressive, growth-oriented investors. NPS can be more suitable for those investing predominantly for retirement and who want lower risk than equity mutual funds and tax benefits. Additionally, investors need to be comfortable with limited liquidity in NPS.

NPS vs ELSS: Key points to remember

  • Both investment avenues are market-linked and hence do not offer guaranteed returns
  • Both NPS and ELSS have outperformed traditional tax-saving options like PPF and fixed deposits in the long term but returns depend upon market conditions and are not fixed. *Past performance may or may not be sustained in the future
  • ELSS offers better long-term growth potential than NPS, while the latter offers more tax benefits.

FAQs:

Is it better to pay tax or invest in the National Pension System (NPS)?

Both paying taxes and investing in NPS or National Pension System serve different financial purposes, making them complementary rather than mutually exclusive. Taxes fund public services, infrastructure, and welfare, while NPS is a long-term strategy for securing retirement income with tax benefits. A balance of both ensures civic responsibility and personal financial security for retirement.

What are the disadvantages of the NPS scheme?

A. National Pension System has a few drawbacks including a long lock-in period until retirement, limited liquidity and mandatory annuity purchase at retirement. It also offers lower return potential than more aggressive equity-oriented mutual funds.

Is NPS a risky investment?

The National Pension System (NPS) carries market risk as its equity and debt investments are subject to market fluctuations. However, the risk is mitigated by diversified investment options and a long-term horizon.

Who should not invest in an Equity-linked Savings Scheme?

Individuals with a low-risk tolerance, short investment horizon (less than 3 years), or those needing immediate liquidity should avoid investing in ELSS, as they are equity-based, subject to market volatility, and have a lock-in period of 3 years.

Which type of investor may not prefer NPS?

Investors looking for an aggressive growth-oriented avenue may find NPS restrictive because it has a 75% equity cap. Investors seeking liquidity may also find the lock-in period challenging.

Should I invest in an Equity-linked Savings Scheme or National Pension System?

Choosing between ELSS and NPS depends on your goals, horizon, and risk tolerance. Those with a higher risk appetite seeking better long-term return potential and who want to invest in goals beyond retirement may consider ELSS. Those looking to build a corpus for retirement along with a pension plan and considerable tax benefits may consider NPS. Investors can also include both in their portfolio to combine retirement planning with other types of goals and to optimise the tax benefits of both.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

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