Nps Vs Mutual Funds: Where Should You Invest Your Money?

Retirement planning is a crucial aspect of financial management, and two of the most popular avenues for individuals are the National Pension System (NPS) and mutual funds. Both investment options offer distinct benefits and considerations, and understanding these nuances is essential for making informed decisions. In this comparison, we will delve into the key features of NPS and mutual funds, highlighting their differences in purpose, investment options, flexibility, tax implications, and more, to provide a comprehensive overview and aid your investment choices.

Tax benefits

NPS

The National Pension System (NPS) offers tax benefits under Section 80C and Section 80CCD(1) of the Income Tax Act, 1961. NPS subscribers can avail of a tax deduction of up to ₹1.5 lakh under Section 80C, along with an extra deduction of up to ₹50,000 under Section 80CCD(1B). NPS also offers tax benefits on partial withdrawals of up to 25% of self-contributions. Additionally, NPS subscribers can claim tax benefits on their contributions, with amounts up to 10% of their salary (Basic + DA) eligible for tax deductions under Section 80CCD(1). NPS has been categorised as an EEE (Exempt-Exempt-Exempt) product, meaning contributions, returns, and withdrawals are all tax-free.

Mutual Funds

Mutual funds, specifically Equity-Linked Savings Schemes (ELSS), offer tax benefits under Section 80C of the Income Tax Act, with tax exemptions on investments up to ₹1.5 lakh. ELSS funds have a lock-in period of 3 years, after which capital gains are taxed based on the holding period. Equity Mutual Funds held for over a year qualify for long-term capital gains (LTCG) tax at 10% on gains above ₹1 lakh. Debt Mutual Funds offer tax advantages if held for more than three years, with indexation benefits.

Risk and volatility

When it comes to risk and volatility, there are several factors to consider when deciding between investing in NPS or mutual funds.

NPS, or the National Pension System, is a government-backed, long-term retirement savings scheme. It is designed to provide financial security and a stable income stream during one's post-retirement years. NPS investments include equities, but the equity exposure is capped to reduce risk. As investors age, the equity portion gradually decreases, ensuring a balanced risk profile. The maximum percentage that can be invested in equities is typically between 50% and 75%, and this limit may decrease by 2.5% annually once the investor reaches a certain age (in some sources, this is specified as 50 years of age). This makes NPS a relatively low-risk investment option, particularly for those seeking a disciplined, long-term retirement plan.

On the other hand, mutual funds are investment schemes that pool money from multiple investors to invest in diversified assets, such as stocks, bonds, or a mix of both. Mutual funds offer a wider range of investment choices and can be used to purchase a higher proportion of equities compared to NPS. While this allows for higher potential returns, it also exposes investors to greater risk and market volatility. The risk levels of mutual funds vary based on the chosen funds and can range from low to very high risk.

In terms of volatility, NPS is generally considered less volatile than mutual funds due to its focus on long-term, stable returns and the restrictions on equity exposure based on age. NPS primarily invests in government securities, corporate bonds, and equities, which are relatively less volatile assets. Mutual funds, however, can vary widely in volatility depending on the type of fund (equity, debt, or hybrid) and market conditions.

It is worth noting that while NPS offers more stability and security, mutual funds offer greater potential for capital growth. The decision between the two depends on the individual's risk tolerance, investment goals, and financial objectives.

Liquidity

NPS:

NPS, or the National Pension System, is a long-term retirement-focused investment vehicle. It is designed to provide a regular income stream after retirement and has restrictions on withdrawals. Tier I NPS accounts, which are mandatory, have withdrawal limitations. Full withdrawals are only allowed after 10 years or at age 60, while partial withdrawals of up to 25% are permitted under certain conditions. NPS investments are also limited, with a maximum of 75% allowed in equities.

Additionally, upon retirement, individuals are required to use a portion of their NPS corpus to purchase an annuity, which provides a regular income. This further limits the liquidity of NPS investments.

Mutual Funds:

Mutual funds, on the other hand, offer greater liquidity. They provide flexibility and are often used as emergency funds. Investors can exit mutual funds at any time, subject to exit load and capital gains tax implications. Mutual funds also offer various lock-in periods, and many have no lock-in at all, providing liquidity when needed.

Open-ended mutual funds, in particular, offer easy entry and exit, making them a popular choice for investors seeking liquidity and diversification.

Comparison:

NPS may be suitable for those who are primarily focused on long-term retirement planning and are comfortable with the associated withdrawal restrictions. On the other hand, mutual funds cater to various financial goals, including wealth accumulation, regular income, and tax savings. They provide investors with the flexibility to access their funds when needed, making them a more liquid investment option compared to NPS.

In summary, NPS has limited liquidity due to its focus on long-term retirement planning and withdrawal restrictions. Mutual funds, with their diverse investment options and flexible withdrawal features, offer greater liquidity to investors.

Returns

NPS Returns:

NPS is a long-term retirement-focused investment vehicle, and its returns are designed to provide a regular income stream after retirement. Historically, NPS investments have delivered annualised returns between 8% and 12%, with some sources mentioning returns of up to 14%. The returns depend on the asset allocation chosen, which can include equity, corporate bonds, government securities, and annuity. The equity exposure in NPS is capped, and as investors age, the equity portion gradually decreases, ensuring a balanced risk profile. This makes NPS a relatively stable and secure investment option.

Mutual Fund Returns:

Mutual funds, on the other hand, offer a diverse range of investment options, including equity, debt, hybrid, and thematic funds. The returns on mutual funds vary significantly based on the type of fund, investment strategy, fund manager expertise, and market performance. Equity mutual funds, which invest primarily in stocks, have a track record of providing higher returns than NPS over the long term, typically in the range of 12% to 18%. Mutual funds also offer the benefit of compounding, where the reinvested earnings grow at the same rate as the returns, further enhancing the overall returns.

Comparison:

While NPS offers stable and consistent returns, mutual funds have the potential to generate higher returns, especially with equity-focused funds. However, it's important to note that mutual funds, particularly equity funds, come with higher risks. The choice between the two depends on your risk tolerance and investment goals. If you are comfortable with higher risk and are seeking higher returns, mutual funds are a better option. On the other hand, if you prefer consistent and stable returns with lower risk, NPS is a more suitable choice.

Investment options

National Pension Scheme (NPS)

The National Pension Scheme (NPS) is a government-backed, long-term retirement savings scheme designed to provide financial security during one's post-retirement years. It encourages systematic savings and investment in a mix of equity and debt instruments. Here are some key points about NPS:

• Purpose: NPS encourages individuals to invest in a pension account during their employment. After retirement, subscribers can withdraw a portion of the accumulated corpus as a lump sum, and the remaining amount is received as a monthly pension.
• Eligibility: Initially limited to central government employees, it is now open to all Indian citizens on a voluntary basis.
• Tax benefits: NPS offers tax benefits under Section 80C and Section 80CCD. Contributions made to NPS are eligible for deductions, making it attractive for salaried individuals.
• Returns: NPS investments include equities, offering historical returns of 9-12% annualised returns over the past decade.
• Risk management: The equity exposure in NPS is capped (between 50-75%). As investors age, the equity portion gradually decreases, ensuring a balanced risk profile.
• Investment options: NPS invests in equity, corporate debt, government bonds, and alternative investment funds as per the investor's choice.
• Withdrawal: Tier I NPS accounts have withdrawal limitations. Full withdrawal is only allowed after 10 years or at age 60, but partial withdrawals of up to 25% are permitted under specific conditions.
• Regulated by: The Pension Fund Regulatory and Development Authority (PFRDA)

Mutual Funds

Mutual funds are a type of investment vehicle that pools money from multiple investors to purchase diversified assets like stocks, bonds, or a mix of both, depending on the investment objective of the scheme. They are managed by fund managers and offer investors a share in the fund's returns and risks. Here are some key points about mutual funds:

• Purpose: Mutual funds serve various financial goals, including wealth creation, regular income, and tax optimisation, depending on the specific scheme's objectives.
• Investment options: Mutual funds provide a diverse range of fund categories, including equity, debt, hybrid, and thematic funds, offering a broader range of investment choices.
• Liquidity: Mutual funds offer schemes with various lock-in periods, and many have no lock-in, providing liquidity when needed.
• Risk levels: The risk levels of mutual funds vary based on the chosen funds, ranging from low to very high risk.
• Tax implications: Taxation depends on the type of fund (equity or debt) and holding period. Equity funds offer tax exemption on long-term capital gains, while debt funds provide indexation benefits after 3 years.
• Regulated by: The Securities and Exchange Board of India (SEBI)

NPS vs Mutual Funds

When deciding between NPS and mutual funds, it is essential to consider your financial goals, risk tolerance, and investment horizon. Here are some key differences between the two:

• Purpose: NPS is primarily designed for retirement planning, with restrictions on withdrawal, while mutual funds offer flexibility for various financial goals.
• Investment options: NPS invests in a limited range of assets, while mutual funds provide a broader range of investment choices.
• Withdrawal: NPS has more stringent withdrawal limitations, while mutual funds offer more liquidity.
• Risk: NPS is generally considered less risky due to its lower equity exposure and focus on government securities and corporate bonds. Mutual funds can vary widely in risk depending on the type of fund and market conditions.
• Tax benefits: Both NPS and mutual funds offer tax benefits, but NPS provides additional tax advantages over and above the Section 80C limit.
• Fund manager: In NPS, fund managers can be changed by the PFRDA based on performance or the subscriber's choice. Mutual funds offer more flexibility, allowing investors to switch between fund managers.
• Returns: Returns for both NPS and mutual funds depend on various factors and can vary. Mutual funds, especially equity funds, have the potential for higher returns but also carry a higher risk.
• Emergency funds: Mutual funds are commonly used as emergency funds due to their flexibility and ability to withdraw funds when needed. NPS, with its withdrawal restrictions, is less suitable for this purpose.
• Flexibility: Mutual funds provide more flexibility in terms of investment choices, withdrawal options, and the ability to cater to diverse investment needs. NPS is more restrictive and primarily focused on retirement planning.

In conclusion, the decision between NPS and mutual funds depends on your individual financial objectives, risk appetite, and investment horizon. NPS is ideal for those seeking a disciplined, long-term retirement plan with tax benefits, while mutual funds offer more flexibility, liquidity, and a wider array of investment choices.

Frequently asked questions