When you invest for your retirement through products such as the National Pension System (NPS) or a retirement plan offered by life insurance companies, the construction of the product is such that at the end of the investment period – at your retirement – you take the accumulated corpus to buy an annuity. An annuity is a retirement product that pays you regular income for life.
But what if when you retire you need a lump sum? The good news is that these products allow you to take some of the accumulated money as a lump sum. In financial jargon, this is called commuting. It basically means an upfront payment of your pension money.
Let us understand the commuting provisions in the NPS and the retirement policies offered by life insurance companies.
NPS is a defined contribution retirement product that requires you to stay invested for up to age 60. It is a market linked product that offers four investment options: Plan G invests in government securities, Plan C in fixed income instruments other than government securities, Plan E in equities (limited at 50% or 75% via the life cycle fund) and regime A in alternative investment funds (limited to 5%). Early withdrawals are discouraged and you can only keep 20% of the money and must purchase an annuity with the remaining 80%. However, partial withdrawals are allowed for certain events.
At age 60, you can withdraw, or what is also known as commuting, up to 60% of the money (40% is tax free and 20% taxable). With the remaining 40%, you must purchase an annuity. Although you pay no tax on the amount allocated to purchase an annuity, the annuity (pension) income you earn is taxable.
Life insurance companies offer pension plans which can be divided into two broad categories: traditional pension plans and unit-linked pension plans (ULPP). Traditional plans don’t disclose investment portfolios or costs. They either offer a guaranteed minimum return and additional bonus returns, or a guaranteed benefit from the start. ULPPs, on the other hand, are market related products in which you can see the costs as well as the performance of the fund.
ULPPs come with a 5-year lock, while in the case of traditional plans, there are heavy redemption penalties, intended to discourage premature withdrawals. By law, a life insurance company’s pension plan must offer a non-zero positive premium return to the policyholder at maturity.
At maturity, you can convert one-third of the accumulated amount and convert the rest into an annuity. The lump sum in your hands is tax free. However, annuity income is taxable. The other option is to use the money and re-subscribe to a single premium pension plan, but at maturity you will still need to convert the minimum amount into an annuity.
Even though retirement plans allow you to convert part of your accumulated corpus to meet immediate needs, financial planners do not like mandatory annuity of retirement money. In fact, as soon as you invest in these plans, you agree to purchase an annuity product several years after retirement.
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