NPS Tier II And Mutual Funds: Which One Suits Your Investment Goals?

The National Pension System (NPS) allows investments through two accounts: Tier I and Tier II. Recently, the Pension Fund Regulatory and Development Authority (PFRDA) introduced the Multiple Scheme Framework (MSF) schemes; however, those are only for non-government subscribers. NPS, due to its equity exposure, is often compared with mutual funds, though mostly in the context of Tier I accounts. The primary reason Tier I is more popular than Tier II is its tax benefits, while Tier II functions much more like a mutual fund.

Here, we discuss Tier II and mutual funds and what you may consider for your goals. While discussing with the experts, three key points emerged that investors need to consider when evaluating NPS Tier II and mutual funds.

Cost:

Is Investing In NPS Tier II Less Costly Compared To Mutual Funds?

Says Ajay Kumar Yadav, Group CEO and CIO, Wise Finserv, a financial advisory firm: “NPS Tier II is one of the cheapest active products in the market. Fund management fees for NPS schemes are in the range of about 0.03-0.09 per cent of assets, depending on the pension fund’s asset under management (AUM) slabs.” 

NPS is known for its low-cost structure, and on the cost parameter, it clearly wins. 

“Even after adding small central recordkeeping agencies (CRAs) and transaction charges, the overall costs are typically far lower than regular mutual funds and usually lower than most direct plans as well, where equity expense ratios often sit between 0.5 per cent and 2 per cent. So yes, from a cost perspective, NPS Tier II clearly scores over most mutual funds.”

To some, this small percentage difference may seem irrelevant, but it can create a significant difference over a long period.

Taxation:

Is NPS Tier II Better Than Mutual Fund Investments In Terms Of Tax?

NPS Tier II does not provide any tax benefit on investment, and this is why it is often neglected when it comes to the mandatory investment to save tax. On the other hand, the tax treatment is also different for both Tier II and mutual funds. While NPS Tier II gains are taxed according to one’s slab rates, gains from mutual funds are handled under capital gain rules. 

S. Ravi, former BSE chairman and founder of Ravi Rajan & Company, says, “The question of the tax benefit is really a differentiator between NPS Tier II and mutual funds. In terms of efficiency from the perspective of both contribution and withdrawal, ELSS and other equity mutual funds are better than the ordinary NPS Tier II account.” 

“Equity and debt mutual funds are taxed under the capital gains framework, with differential treatment for long-term and short-term holdings. That usually results in a more efficient post-tax outcome for long-term investors, especially in equity and asset allocation funds. So, in most practical cases, mutual funds remain superior to NPS Tier II from a tax efficiency angle”, says Yadav.

Liquidity:

How Liquid Is The Money Invested In NPS Tier II Compared To Mutual Funds?

Adds Ravi: “NPS Tier II’s attractiveness springs from its liquidity and low expense ratio, not its tax status. It has been designed to be highly liquid, with no general lock-in period.”

Investment in an NPS Tier II account is highly liquid. A subscriber can enter and exit anytime. Unlike this, mutual funds do not always have a lock-in period, but charge an exit load for withdrawing money before a minimum period stipulated by them. Yadav shares that one can redeem partially or fully from NPS Tier II any time, and the money is usually credited in a T+2 type settlement period, similar to mutual funds.

What Should You Choose From These Two Market-Exposed Liquid Investment Options?

Needless to say, no single investment scheme is suitable for everyone or for every goal. While both options offer 100 per cent investment in equity, mutual funds offer more variety and tax saving options, while NPS wins in terms of costs. On the liquidity factor, both are highly liquid.

Says Yadav: “From an advisory perspective, I see NPS Tier II as an ultra-low cost execution vehicle that can complement, not replace, mutual funds. For most investors, the right approach is to use NPS Tier I for tax-efficient retirement accumulation, use mutual funds as the core for flexible and tax-efficient wealth creation, and selectively use Tier II where very low-cost implementation within the NPS ecosystem is a priority.”