12 May 2013

Unique way of investing in NSC (National Savings Certificate)

If you belong to the same generation as me (born in mid-late 80s), then chances are that you would have heard about NSCs, but would not have invested in them. But if you are of a generation prior to me, then chances are high that some of your money might be invested in this instrument.

NSC stands for National Savings Certificates. These are reliable, tax efficient (tax exempt under section 80C) and guaranteed by the govt. You can read more about it here.


national savings certificate
National Savings Certificate

So why is it that my generation is neglecting this instrument? 

The main reason behind this is instrument's so called 'lower returns'. Lower when compared to more glamorous returns claimed by riskier ones like equities, mutual funds and ULIPs. Returns offered by NSC are between 8.5% and 8.8% depending on the flavour (5 year or 10 year) you chose. But since interest is calculated six monthly, the effective rate ranges between 8.78% and 9.00%. And that is not all. Investment in NSC can be claimed as a deduction under Section 80C. Also, the interest income is tax-exempted. So returns are much higher than what it seems at first glance. And these are assured returns with almost no risk, unless the govt. decides to default. :-)

But there is another problem with NSCs. These instruments have a lock-in of 5 years and 10 years. Now this is an extremely long period for our impatient generation. But there is a way in which this lock-in can be managed in a way that an investor receives some money at the end of every year. The approach which I'll discuss increases the liquidity of NSCs, with a little help from Fixed Deposits. This approach reduces the return a little. But that is a price we need to pay for increased liquidity. :-)

I'll refer to this approach as the NSC-LADDER. We use NSCs and Bank Fixed Deposits (for initial period of the strategy) in this approach. So here it goes...

Suppose at the start of time (Year 0), you have Rupees One Lac (Rs 1,00,000) to invest. Though you are ready to invest for long term, you are not very comfortable with the lock-in of 5 years (or 10 years) and want to invest (safely) in some (reliable) instruments which have some amount of liquidity. The interest rates on NSC & FDs of different tenures is as follows - 

Interest Rates NSC
Interest Rates - NSC & Fixed Deposits

You start by dividing this one lac into five parts of Rs 20,000 each. You invest first in a bank FD with maturity period of One Year. Invest the second in a FD of 2 Years, third for 3 years, fourth for 4 years and finally fifth for 5 years.

After this, what happens is that you receive maturity amounts from respective FDs at the end of first, second, third, fourth and fifth year. The maturity proceeds are in turn invested in 5 year NSCs starting from start of Year 2, 3, 4, 5 and 6. 


NSC Ladder : Click to enlarge

This is what exactly happens -

  • 1st Tranche: Invested Rs 20,000 in FD for One Year - Received Rs 21,600 at end of Year 1 - This sum is invested in NSC for 5 Years - Received Rs 32,750 at end of Year 6.
  • 2nd Tranche: Invested Rs 20,000 in FD for Two Years - Received Rs 23,545 at end of Year 2 - This sum is invested in NSC for 5 Years - Received Rs 35,699 at end of Year 7.
  • 3rd Tranche: Invested Rs 20,000 in FD for Three Years - Received Rs 25,901 at end of Year 3 - This sum is invested in NSC for 5 Years - Received Rs 39,271 at end of Year 8.
  • 4th Tranche: Invested Rs 20,000 in FD for Four Years - Received Rs 28,232 at end of Year 4 - This sum is invested in NSC for 5 Years - Received Rs 42,805 at end of Year 9.
  • 5th Tranche: Invested Rs 20,000 in FD for Five Years - Received Rs 30,073 at end of Year 5 - This sum is invested in NSC for 5 Years - Received Rs 45,597 at end of Year 10.
As illustrated above, you keep receiving maturity proceeds at the end of year 6, 7, 8, 9 and 10. These proceeds in turn can be reinvested in further NSCs of five years, maturing at end of year 11, 12, 13, 14 and 15. This system creates a Ladder-like System, where every year there is a payout. Our initial concern was that NSCs have a long maturity period with long lock-ins. This results in money getting stuck and reduction in liquidity. But this LADDER approach addresses this concern and generates cash (maturity proceeds) at the end of each year.

Money available at end of each year : Click to enlarge

Now, you can continue this ladder for as long as you like and see the magic of compounding take shape. I know it is tough to plan for 10-15 years. But here, the best part is that once you have invested Rs 1,00,000 in first year, it keeps on rolling without any further investments. Also, interest earned by NSC in first 4 years is tax exempt as it is reinvested and paid out only once at maturity. So tax benefits are immense.

So, is this product for everyone?

No. It is for those who believe in long term wealth building using stable, reliable and risk free instruments. NSC can be one of the instruments if you want to diversify your portfolio.


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17 comments:

  1. Thanks. The biggest problem I see why people from our generation don't invest in NSC is the lack of online options. For FD all transactions can be done while sitting at home with netbanking.

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  2. @anon.coder
    You are right. If govt could come up with an online option, maybe a lot of people might get interested in this option.

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  3. I think doing a Recurring Deposit can also be beneficial...

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  4. @Rahul
    Yes. RDs can be useful when you have some planned expenditures in near future. You can then save for the expenditure in disciplined manner.

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  5. A good idea stableinvestor.
    Can you please inform us about the tax that we would have to pay for the interest.
    Say I keep using this strategy for 20 years after investing the 1 lakh

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  6. KnowledgeSeeker13 May 2013 at 12:35

    The article mentions that: "Also, the interest income is tax-exempted"

    ReplyDelete
  7. Yeah correct. However, I remember one of my friends saying that if the interest earned is greater than 10k per year then it will be liable to tax.
    Please correct me if wrong.

    Also, for NSC, Investment up to INR 1,00,000/- per annum qualifies for IT Rebate under section 80C of Income Tax Act.
    What implications does this have, suppose I am willing to invest 2 lakh a year in NSC?

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  8. @wickedOne
    Thanks for the compliment.
    And what you suggested can also be an option. You can start with NSCs from first year itself. :-)

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  9. @taklubaba
    You will only get a rebate upto a lac rupees.

    ReplyDelete
  10. This seems to be a good idea.But i have one question here..Suppose we carry with this "Ladder approach" for 25 years.What about the total tax that we will incur after the maturity of each FDs after their respective maturity s. Wont that eat a large chunk of the total amount that we will receive after lets say 25 years?

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  11. In this particular example, the FD mature after 1, 2, 3, 4 & 5th year. So FD related taxation would have to be dealt with for first 5 years only. We switch to NSCs after the end of maturity of each of these FDs. But in case you want to make a ladder of FDs and continue it for 25 years, then its true that tax would reduce your earning susbstantially.

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  12. Thanks for the reply.... I was planning to invest in NSC for one year and then keep renewing the matured NSCs as and when they mature.Is this a nice idea..if not can u suggest any other ways to better utilize this?

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  13. Seems like a good idea. We assume you would have invested in other asset classes as well. NSC alone may not be suffice.

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  14. You mentioned "...the interest income is tax-exempted..."

    That is not completely true - OR so I understand. Here is what my understanding is, with regards to interest earned from NSC investments...

    - The capital investment in N.S.C.s qualifies for rebate u/s 80C in the first year of investment.

    - Thereafter (after completion of one year) for the next 5 years the annually accrued interest on N.S.C.s is eligible for rebate u/s 80C as it is considered reinvested in N.S.C.s

    - Also this annually accrued interest is taxable on an accrual basis every year under the head ‘Income from Other Sources’.

    - If the accrued interest is not taxed every year on an accrual basis than the entire income becomes taxable during maturity / withdrawal.

    - the final year’s interest, when the NSC matures, does not receive a tax deduction as it does not get reinvested, but is paid back to the investor along
    with the interest of the earlier years and the capital amount.

    Source 1:http://www.caclubindia.com/forum/nsc-interest-taxation-69147.asp#.UhTAMWf7q28

    Source 2: http://taxguru.in/income-tax/nsc-tax-benefit.html

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  15. The Biggest problem with the current generation investing in such an Instrument is the tax liability..NSC investment is only viable for small amounts. There is no maximum limit for NSC investment and hence it would not be surprising if people had 1cr+ to invest in a safe,risk free instrument. But assuming its a 1 time investment you have an additional income of 9l pa out of which 1l is tax deductable. The problem now is since NSC is cumulative you would have to pay your taxes from other investments. If you choose to pay at the end of the maturity period of 10 years for a 1cr investment you would have accrued an interest of 1.34l which would then be taxable :(

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  16. stable investor, coorect me if i am wrong. if we keep makingladder, there is no income or payout at the end of every yr. Am I right?

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  17. Hmm... True. One can always exit the ladder when one wants to. Isn't it?

    ReplyDelete

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