NPS vs. SIP: Which is a better investment plan?

Retirement planning is one of the most common aspects of financial strategising and investing. When it comes to potentially building wealth for retirement, Systematic Investment Plan (SIP) in mutual funds and National Pension System (NPS) are two popular choices. Both have their pros and cons, and the more suitable option depends on your financial goals, risk appetite, and investment horizon. In this article, we’ll compare NPS vs. SIP in mutual funds, explain their benefits, and help you make an informed decision.

• Table of contents

• Systematic Investment Plan (SIP)
• Advantages of SIP
• National Pension Scheme (NPS)
• Benefits of NPS
• NPS vs. SIP: Which is more suitable?
• Tax implications on NPS and SIP

Systematic Investment Plan (SIP)

A Systematic Investment Plan (SIP) is a method of investing in mutual funds. It allows you to invest affordable amounts regularly, typically every month. Instead of putting a lump sum amount at once, you can build wealth gradually over time.

SIPs are flexible, and you can choose how much to invest and for how long. They work well for beginners and experienced investors alike.

Advantages of SIP

Affordable and flexible

• You can start investing with an amount as small as Rs. 500 per month in general, which makes it accessible for everyone, including students or individuals with limited disposable income.
• You have the freedom to stop, pause, or modify your SIP anytime without penalties, offering better control over your investments.

Diversification

• SIPs invest in a diversified portfolio of securities through mutual funds. Depending on the scheme category, mutual funds may invest in stocks, bonds or a blend of both. They may also invest in other asset classes such as commodities and may diversify across sectors and market capitalisations.
• This reduces the overall risk because your money isn’t tied to a single company or sector. So, if one asset underperforms, others can potentially offset or mitigate the impact.

Wide variety of schemes

• There are multiple scheme categories catering to various financial objectives such as long-term wealth creation potential, relative stability of capital and a combination of the two.
• Options include equity, debt, commodities, depending upon the scheme category.
• Investors can choose schemes aligned with their risk appetite, from relatively low risk debt funds to high risk equity funds.
• Specific schemes target sectors like technology or themes like ESG, offering niche investment opportunities.
• The variety in scheme categories can make mutual funds suitable for short-term, medium-term, long-term and very long-term goals.

Compounding benefits

• The longer you stay invested, the more your money can potentially grow over time through the power of compounding. Compounding happens if the returns on your investment are reinvested and go on to earn further returns. Over time, this can create a snowball effect.
• Even affordable but consistent contributions have the potential to result in significant wealth creation if you remain invested for the long term.

Rupee cost averaging

• SIPs allow you to buy more units when prices are low and fewer units when prices are high, reducing the need for timing the market.
• This helps smooth out the impact of market volatility on your investments, making it a suitable way for novice investors to access the financial markets.

No lock-in period

• Most mutual funds do not have a lock-in period, giving you the freedom to redeem your investment anytime.
• This liquidity ensures that you have access to your funds in case of emergencies, making SIPs a versatile investment option.

National Pension Scheme (NPS)

The National Pension Scheme (NPS) is a government-backed retirement plan that seeks to provide financial security in your golden years. With NPS, you can invest in a mix of equity, corporate bonds, and government securities. Moreover, it has several tax benefits. NPS has a lock-in period until retirement, making it suitable for long-term investors looking to save for retirement in a government-backed avenue.

NPS has two types of accounts: Tier 1 and Tier 2. The latter does not offer tax benefits. An investor must have an NPS Tier 1 account to open a Tier 2 one.

Benefits of NPS

Retirement-focused investment

• NPS can strengthen stability after retirement by giving you a steady income through an annuity plan.
• You can also withdraw some capital (up to 60%) as lumpsum

Risk-return balance

• NPS also offers market-linked returns and carries risk. However, the government-backing may offer a layer of stability.
• Equity exposure in NPS is capped at 75%, unlike equity mutual funds where there is no upper limit.

Tax benefits

• NPS offers several tax benefits (detailed below)

Employer contributions

• Some employers contribute to their employees’ NPS accounts
• These contributions are also eligible for tax benefit.

Partial withdrawals

• NPS allows limited withdrawals for specific purposes after completion of three years.

NPS vs. SIP: Which is more suitable?

The choice between NPS vs SIP depends on several factors, such as:

1. Purpose
   • SIP can be suitable for potential wealth creation for retirement as well as for other short, medium or long-term goals.
   • NPS is mainly oriented towards retirement planning
2. Risk
   • SIP: Depends upon the scheme portfolio composition. Mutual funds that invest predominantly in equities are usually categorised as very high risk. However, debt mutual funds are relatively stable and hybrid funds diversify across asset classes to optimise the risk-reward potential balance.
   • NPS: Depends upon the portfolio, but equity investments are capped at 75%. Returns are still market-linked and hence carry risk, though the government-backing may add a layer of stability.
3. Liquidity
   • SIP offers higher liquidity since you can withdraw your investment anytime.
   • NPS has restrictions on withdrawals before retirement.
4. Return potential
   • SIP in equity-oriented funds has the potential for higher returns in the long-term, depending on market conditions and the mutual fund’s performance.
   • Depends upon the equity allocation in the portfolio. An equity-oriented portfolio has the potential to provide inflation-beating returns in the long term, but the 75% cap on equity can limit growth potential when compared to equity mutual funds with more equity-oriented portfolios.
5. Choice of investments
   • Mutual funds offer several scheme types, so investors can choose a portfolio mix that is suitable to them. They can also invest in multiple schemes for broader diversification.
   • Limited options.
6. Tax benefits
   • Among mutual funds, only ELSS (Equity Linked Savings Schemes) offers tax benefits.
   • NPS offers several tax benefits.

Tax implications on NPS and SIP

Tax benefits are a key factor when deciding between NPS and SIP. Let’s break it down:

1. Tax implications on NPS
   • Investments of up to Rs. 1.5 lakh in NPS are eligible for deductions under Section 80CCD (1) and an additional Rs. 50,000 under Section 80CCD(1B) of the old regime of the Income Tax Act, 1961.
   • Up to 60% of the corpus is tax-free.
   • Up to 60% of the total corpus received as lumpsum at the time of exit is tax-exempt
   • Amount used for purchase of annuity plan is tax-exempt
   • Annuity income is taxable as per your income tax slab.
2. Tax implications on SIP
   • Among mutual funds, only ELSS (Equity Linked Savings Schemes) offers tax benefits under Section 80C of the old regime of the Income Tax Act, 1961. Under this provision, investments made under Sections 80C, 80CCC, 80CCD (1) of up to Rs. 1.5 lakh in a financial year can be deducted from your taxable income.

Conclusion

Choosing between NPS vs SIP depends on your financial goals and risk appetite. Both NPS and SIP can be suitable for long-term goals such as retirement. However, NPS may offer less flexibility, customisability and liquidity than mutual funds. However, for other short, medium or long-term goals, SIPs in mutual funds may be more suitable. In terms of risk, both NPS and SIPs in mutual funds offer market-linked returns, which are not assured or fixed. However, the equity exposure in NPS may be less than that of some equity mutual funds, which may reduce the risk profile to a degree. When it comes to tax efficiency, NPS may offer advantages over SIPs in mutual funds.

A well-rounded investment plan can combine SIPs in mutual funds for better long-term growth potential and flexibility with NPS for relative stability and more tax benefits.

FAQs

What are the key differences between NPS and SIP as investment options?

NPS is a retirement-focused, government-backed plan with low risk, while SIPs invest in mutual funds and are suitable for wealth creation with higher risk and returns.

Which is a more tax-efficient investment: NPS or SIP?

NPS offers better tax benefits with additional deductions under Section 80CCD(1B). SIPs have limited tax benefits depending on the type of mutual fund.

Can NPS and SIP be combined for a diversified investment strategy?

Yes, combining NPS and SIP helps balance risk and returns while addressing both short-term and long-term goals.

Which option offers better long-term returns: NPS or SIP?

SIPs generally offer higher returns due to market exposure. However, NPS provides stable, moderate returns with lower risk.

What are the risk factors involved in investing in NPS versus SIP?

SIPs are market-linked and carry higher risk due to market fluctuations. NPS has lower risk as it invests a larger portion in debt instruments.

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 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.