An additional tax deduction of R50,000, introduced by the finance minister in the last budget, under Section 80CCD(1B) on the contributions to the National Pension Scheme (NPS) is a major draw for some investors. This was over and above R1.5 lakh tax deduction permitted under Section 80C of the Income Tax Act. However, many investors can't make up their mind whether they should go ahead with the investment because of their lack of familiarity with the NPS and its rather rigid structure. Many of them are wondering whether it is better to let go of the tax benefit and invest the money in an equity mutual fund. The strategy is worth a serious consideration as it gives an investor full control over his investment and the accumulated corpus. It is also tax-efficient.

The NPS is open to all the Indians who want to save for their retirement. One can invest in the NPS throughout the working life, and withdraw 60 per cent of the money and use the rest of the corpus to buy an annuity to draw a regular pension on retirement at 60. NPS also offers different investment options with varying risk. Investors can choose an option that matches their risk appetite. An equity mutual-fund scheme is a plain vanilla product which investors can use to accumulate their retirement corpus.

However, equity mutual funds have an edge over NPS on two counts. One is taxation. Investors need not pay any tax on the returns on investments in equity mutual funds held over a year. The withdrawal from the NPS is taxed. The money will be added to the income of the investor and taxed as per the applicable tax slab. Even annuity income, bought with the remaining corpus, is taxable.

Another limitation of the NPS is its limited exposure to equity. The maximum allocation in the NPS towards equity can be only 50 per cent. This investment strategy may rob investors of a chance to create more wealth over a long period as equity has the potential to offer superior returns in the long term. This is the main reason why many investors want to figure out whether it is better to pay taxes and park the remaining money in equity mutual funds that invest all the money in equity.

Let us find out the likely outcome in 20 years. See the two scenarios below. In the first scenario the return on debt is taken to be 8 per cent and that on equity is 15 per cent. In the second, these are 6 per cent and 12 per cent, respectively. For the sake of simplification, we will work with a one-time investment of R50,000 in NPS andR35,000 (assuming that the person has paid 30 per cent tax onR50,000) in an equity fund. In the NPS, R25,000 will go towards debt and an equal amount would be invested in equity. The equity mutual fund will invest the full amount in equity.

As you can see, the equity fund makes more money than the NPS investment. This is despite the fact that the investor has invested a smaller amount in the equity fund. Also, the investor doesn't have to pay any taxes on withdrawal from the equity fund and he has full freedom to decide what to do with the accumulated corpus.