NPS – Are you overestimating the tax benefit?

NPS or National Pension Scheme is emerging as one of the favourite tax saving options for investors.

Under the Income Tax savings options, there is a special benefit provided for investments made in NPS. For additional investments upto Rs. 50,000 under Sec 80 (CCD), there is no tax applicable. This is over and above the section 80C investment limit of Rs. 1.5 lakhs.

Now, if you are in the highest tax bracket, you save 30% tax on this amount, that is, approx. Rs. 15,000.

So far so good.

The problem starts when you start counting your NPS tax benefit of Rs. 15,000 twice. In fact this is what several investors are doing.

Here’s how.

To repeat, investment of Rs. 50,000 in NPS saves taxes @30% (assuming highest tax bracket), that is Rs. 50,000. You earn a return on this investment amount of Rs. 50,000.  Fair enough.

Now you go on to assume that the tax saving of Rs. 15,000 is also available to you to invest and can also earn returns.

In this you are counting your total investment in NPS as Rs. 50,000 + Rs. 15,000, that is, Rs. 65,000.

This is incorrect. 

It is a big fallacy and leads to double and erroneous counting of tax benefits.

Here’s a simple way to understand your tax benefit and use it to make your investment decision. 

Suppose you have Rs. 50,000 to invest. You have 2 options.

Option 1: Invest in NPS and save taxes.

Option 2: Invest in Balanced Mutual Fund but no tax saving.

Assuming you are in the 30% tax bracket, what is the final amount available for you to invest in both the options?

Option 1: The entire Rs. 50,000 is available to invest in NPS since there you save on tax payout.

Option 2: You have to first pay tax @30% and thus you are left with only Rs. 35,000, which you can invest in the balanced mutual fund.

Remember, you cannot count your investment as Rs.50,000 + Rs. 15,000 of tax savings for NPS.

It is because you were able to save tax that the entire Rs. 50,000 is available to invest. That is your only benefit.

By overestimating and double counting this tax benefit in NPS, you are probably making an incorrect investment decision.

Now rethink your investment strategy and make your choice accordingly.

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Have you fallen prey to this or any of your colleagues? Do share with us.