If you invest in stocks, directly or through mutual funds, you need to pay securities transaction tax (STT) as well as dividend distribution tax (DDT) whenever the company or stock distributes dividends. However, when you invest in stocks through the National Pension System (NPS), no such tax is levied.
NPS, in its private sector avatar called the All Citizen Model, allows up to 75% investment in equity for persons below the age of 50. Even after the age of 50, this limit is only gradually tapered off by 2.5% each year to finally reach 50% at the age of 60 when the account matures. Even government employees in NPS can invest up to 50% of their corpus in equities under the new rules announced in December 2018.
NPS investments in equity are made through pension funds, but it is the NPS Trust that invests on behalf of the subscribers. The NPS trust is exempt from paying both STT and DDT and that benefits the subscribers. Although mutual funds are also structured as trusts, they don’t enjoy such exemption.
STT is charged at 0.1% of the transaction value. Hence, every time you buy or sell shares worth ₹5 lakh, you have to pay STT of ₹500. When your mutual fund buys and sells shares, the money is deducted from the net asset value (NAV). This doesn’t happen in the case of NPS.
DDT is charged at 20.56% (including surcharge and cess) when a company pays a dividend. For example, if a company pays a dividend of ₹10,000, a sum of ₹2,035 will be deducted towards DDT and you will only get ₹7,965. If you have invested in the company through a mutual fund, the latter will get this reduced amount of ₹7,965 and your NAV will rise by a corresponding lower amount. However, there’s no tax to pay in case of NPS and the full dividend of ₹10,000 will get credited to your account.
Note that if you opt for the dividend option on your mutual fund, you will be subject to a second layer of DDT. This amounts to 11.648% (including surcharge and cess) on equity-oriented funds and 29.12% (including surcharge and cess) on debt funds.
You can make up to three partial withdrawals, which are tax-free, from NPS on specific grounds up to 25% of your contributions, before the account matures.
Finally, if you directly hold stocks and receive dividends of more than ₹10 lakh in a year, you have to pay another layer of tax at 10% on the amount received. This is once again not applicable if the same amount of dividend gets added to your NPS corpus.
The STT and DDT exemptions may seem small, but their effect can compound over time. Consider these costs when choosing a retirement product. Funds and stocks can also help build a retirement corpus, but they do not have as many tax advantages as NPS.