NPS taxation rules change as often as the weather and are infinitely complicated. Here’s an attempt to demystify them.
For those looking to accumulate a sizeable sum towards retirement, the Tier 1 account of the National Pension System (NPS) offers quite a few advantages – it is market-linked, has delivered reasonable performance, charges a very low management fee and offers flexible switches between asset classes and managers. But it has some negatives too and a key one is its complicated taxation.
While the tax burden on Tier 1 NPS subscribers has been reduced in stages, in recent years, its taxation remains quite complicated compared to other retirement vehicles. The taxation of retirement vehicles is usually evaluated at three stages – the contribution/accumulation stage, the return earning stage and the final withdrawal stage. Here’s a simple guide on how NPS is taxed at each stage.
Under section 80CCD (1) of the Income Tax Act, any individual can avail of tax breaks on his annual contributions to the NPS Tier 1 account. But no matter how much you decide to invest in the scheme, the tax breaks that you can claim are subject to some strict limits.
Under 80CCD (1)
# 1 If you are a salaried employee working in the private sector, the tax exemption on your NPS contribution is capped at 10% of your salary (Basic pay plus DA) or 10% of your gross total income, whichever is less. If you are a Central government employee, you are allowed a slightly higher cap of 14% of your salary or gross total income.
The tax laws are slightly more liberal with self-employed folk contributing to the NPS, perhaps because they wouldn’t receive an employer’s contribution. The self-employed can claim a tax exemption on their NPS contribution going upto 20% of their gross total income.
But do note that whether one is a private employee, a government employee or a self-employed person, the total exemption one can claim towards NPS contributions in a year under section 80CCD(1), cannot exceed the overall cap of Rs 1.5 lakh a year. However, a separate section 80CCD(1B) allows you to claim more (covered further below).
#2 If you are a prodigious saver who likes to max out his tax saving investments under section 80C, the NPS exemption under section 80CCD(1) may not be of much help to you. This is because the tax exemption mentioned above on your NPS contributions needs to fit within your overall 80C limit of Rs 1.5 lakh a year. You must be aware that section 80C of the Income Tax Act that allows you to claim tax exemptions of upto Rs 1.5 lakh a year when you invest in a specified list of savings and protection instruments.
This list includes items such as premiums on life insurance, investments in ULIPs, investments in small savings schemes, EPF contributions etc. If you are already claiming tax breaks of Rs 1.5 lakh a year under section 80C by way of investments in the above instruments, you will not have any room left for claiming the section 80CCD(1) tax break on your NPS contribution. In case your 80C investments are less than Rs 1.5 lakh, you can use your NPS contribution to fill the gap.
Under Section 80CCD(1B)
# 3 To help out folks who may have maxed out their 80C tax breaks, the taxman does offer an additional sop for NPS subscribers. Under a supplementary section 80CCD (1B), taxpayers can claim an additional tax exemption of upto Rs 50,000 a year exclusively towards their NPS contribution every year. This is applicable to all kinds of NPS subscribers and is applied over and above anything you already claim under section 80C.
In contrast, the tax rules on your contributions to popular retirement vehicles such as the Employees Provident Fund (EPF) and Public Provident Fund (PPF) are quite straight-forward. In both cases, your entire contribution is eligible for tax breaks under section 80C subject to the overall limit of Rs 1.5 lakh a year.
If you have a corporate NPS account (that is, you opened your account through your employer), your employer may chip in with annual contributions to your NPS account too. There are some additional freebies for you in such cases, under section 80CCD(2). If yours is a corporate NPS account, your employer’s contribution to your NPS is tax-exempt to the extent of 10% of your salary if you are a private employee and 14% if you are Central government employee.
If you’re a highly paid employee though, your employer’s contribution may not escape the tax net. A new googly introduced in the 2020 Budget stipulates that of your employers’ contribution to the NPS exceeds Rs 7.5 lakh a year, both the contribution and the returns it earns will be treated as taxable income.
To simplify, any contribution that you make to the NPS of upto Rs 50,000 a year earns you a guaranteed tax exemption. Whether contributions beyond this limit fetch you any tax breaks depends on your employment status (salaried – private/government, self-employed) and the room you have left under section 80C. If you have a corporate NPS account, you can get your employer to chip in and earn partial tax breaks on this perk.
NPS Taxation: Your returns
Unlike the EPF or PPF, where the fund credits interest to the subscribers every year, the NPS earns you market-linked returns from assets such as equities, corporate bonds or government securities that accumulate in your account until you finally withdraw your proceeds.
The annual interest credits on the EPF and PPF are specifically exempt from tax. In the case of the NPS, the taxation of returns effectively depends on the taxation of your final maturity proceeds.
Your contributions to the NPS are normally locked in until you turn 60. But the scheme allows you to withdraw part of your contributions before maturity if certain conditions are met. NPS investors can opt for premature withdrawal with an overall cap of 25% of their own contributions (employers’ contributions and accumulated returns cannot be withdrawn) if:
- They have completed 3 years with NPS
- They plan to use the amount towards education/marriage of their children, purchase of a residential house, treatment of specified critical illnesses, starting a new venture.
- They cap the number of withdrawals from the scheme to 3 times throughout their holding period in the fund
Such partial withdrawals are exempt from tax and will not be considered part of your taxable income for the year in which you make the withdrawal.
You’ve finally turned 60, have hung up your boots and are looking to get your hands on the fat sum you’ve accumulated in your NPS account. What are the taxation rules? Well, the NPS rules mandate that you must invest at least 40% of your final proceeds from the scheme in an annuity plan that will give you regular monthly or yearly pension. This portion of your corpus is not taxed at withdrawal. But unfortunately, the pension income that you will receive from the annuity plan will get taxed at your slab rate. Earlier, the remaining 60% that you took home as lumpsum from the NPS was taxed too. But thanks to concessions extended over successive budgets, this 60% is now completely exempt from tax.
What happens if you need to close your NPS account because you opted for early retirement or VRS? Well, in such cases, there are strings attached. If you close your NPS account before the age of 60, 80% of your maturity proceeds (your contribution, employers’ contribution plus returns) needs to be compulsorily used to purchase an annuity. While the initial sum invested in the annuity is not taxed, the pension income you receive is taxable at your slab rate every month. The remaining 20% that you withdraw as lumpsum is tax-exempt. This makes early account closure quite unattractive with the NPS.
Ultimately, it is in the treatment of the final maturity proceeds that the NPS loses out materially to other retirement vehicles such as EPF and PPF. Both the EPF and PPF give you a completely free hand in deciding how you will allocate your retirement proceeds between regular income and growth and risky and non-risky assets, rather than strait-jacketing you into low-return annuity schemes. The maturity proceeds from both vehicles are tax-free.
NPS too would be in the same boat, were it not for its compulsory annuity feature which subjects 40% of your final corpus to tax at your slab rates, that too when you need income post-retirement. Hopefully, future FMs will see virtue in doing away with this draconian requirement.
Our earlier article on NPS asset allocation is here
You can refer to NSDL’s FAQs on NPS tax benefit here.