The National Pension System (NPS), established in 2004, is a government-backed pension program. 

Initially exclusive to government employees, it became accessible to the general public in 2009. Under NPS, individuals can contribute to their accounts while employed and withdraw funds upon reaching the age of 60. 

In essence, NPS functions as an annuity product designed to serve as a retirement fund for individuals after they exit the workforce. 

NPS offers two distinct categories: Tier 1 and Tier 2 accounts. Tier 1 serves as the primary NPS account for building a retirement corpus, while Tier 2 operates like a voluntary savings account with greater flexibility for deposits and withdrawals.

Difference Between Tier 1 And Tier 2 Accounts: The main difference between the NPS Tier 1 and Tier 2 accounts lie in the mandatory annual contribution for Tier 1, while Tier 2 account allows account holders to skip payments due to its no lock-in period. 

The NPS Tier 2 account functions like a flexible savings account, enabling withdrawals at any time. 

According to Vishal Dhawan, CEO, and founder of Plan Ahead Wealth Advisor, a Sebi-registered investment advisor (RIA), there are two significant distinctions between Tier 1 and Tier 2 accounts.

“First, Tier 1 accounts offer tax benefits under the old tax regime, whereas Tier 2 accounts do not provide any tax benefits. Second, Tier 1 accounts generally have lower liquidity options compared to Tier 2 accounts. Therefore, it is crucial to plan your contributions carefully based on these differences,” says Dhawan.

Distinctions To Consider When Choosing An Investment Account 

Eligibility: Any Indian citizen aged between 18 and 65 can open a Tier 1 account and obtain a Permanent Retirement Account Number (PRAN). However, to be eligible for a Tier 2 account, one must already be a member of NPS Tier 1. 

Lock-In Period: NPS Tier 1 has a lock-in period until the subscriber reaches 60 years of age, whereas Tier 2 has no such restriction, allowing for immediate fund withdrawals. 

Contributions: The minimum contribution for opening a Tier 1 account is Rs. 500, while for a Tier 2 account, it is Rs. 1,000, marking a significant difference between the two. 

Tax Benefits On Contribution: NPS Tier 1 offers tax deductions of up to Rs 1.5 lakh under Sec 80CCD (1) and Rs 50,000 under 80CCD (1B). However, such tax benefits are not available for Tier 2 accounts. 

Taxation On Withdrawal: At maturity, the entire amount in NPS Tier 1 is tax-exempt, whereas in a Tier 2 account, the corpus is added to the investor’s taxable income and taxed at the applicable slab rate, leading to substantial tax benefits in Tier 1. 

Despite these differences, both NPS Tier 1 and Tier 2 share similar functionalities, such as identical fund management charges and investment options like equity, corporate debt, government securities, and alternative investment funds.

Understanding these variations can help in assessing the suitability of Tier 1 and Tier 2 accounts for individual investment needs. 

NPS Tier 1 And NPS Tier 2 – Which One To Choose?

Investors in Tier 1 may benefit from a tax exemption of up to Rs 50,000 under Section 80CCD (1) for additional investments. They can also avail of deductions for premature withdrawals and annuity purchases. On the other hand, the NPS Tier 2 account does not offer any tax advantages, leading to a significant reduction in potential tax savings. 

Tier 1 accounts have more limited withdrawal options before maturity, thus making them less flexible in this regard. In contrast, Tier 2 subscribers can make early withdrawals to cover various expenses, allowing them to manage their financial needs more effectively using the accumulated funds. Each account type, Tier 1 and Tier 2, has its own merits and demerits. Thus, it is crucial to carefully consider all factors before deciding which one suits your needs best. 

Says Archit Gupta, founder and CEO, Clear, a tax portal: “Although the majority of investments are typically made in either Tier 1 or Tier 2 accounts, it is possible and practical to maintain both investments simultaneously. As a new investor, you can open both a Tier 1 and a Tier 2 account concurrently.”