With limited withdrawal allowed before retirement, NPS is a true retirement product. The Government has also pushed NPS through greater tax incentives. Some of the benefits are exclusive to NPS investments. You can read about National Pension Scheme in detail here. NPS exit and withdrawal rules have been revised after this article was posted. You can read about revised exit and withdrawal rules from NPS in this post.
An aspect of NPS which is not very clear or at least makes a number of investors uncomfortable is the taxation on maturity. NPS falls under EET (Exempt-Exempt-Taxable) basket i.e. investment in NPS gets you deduction in your taxable income. Income/interest/gains on NPS are not taxed (unlike fixed deposits). However, maturity proceeds are taxable. This is unlike Public Provident Fund which falls in the Exempt-Exempt-Exempt (EEE) regime. This does not mean PPF is a better investment instrument than NPS. It is just that PPF faces a favourable tax regime. Please understand your investment decision shall not be driven by tax considerations alone.
In this post, we look at tax benefits available for investments in NPS and tax treatment of NPS withdrawal proceeds.
Update March 1, 2016: This is an old post on NPS taxation. Post announcement in Union Budget 2016, the taxation of maturity proceeds has been made more benign. Do go through this updated post on NPS taxation.
Tax benefits on Investment in NPS
- Investment up to Rs 1.5 lacs into NPS in a financial year is eligible for deduction under Section 80CCD(1). Please note this deduction comes under the overall ceiling of Rs 1.5 lacs for deduction under Section 80C. In case of an employee, this deduction is additionally capped at 10% of his salary (Basic + DA). In case the subscriber is self-employed, this deduction is capped at 10% of his gross total income.
- Up to Rs 50,000 per financial year for any investments into NPS under Section 80CCD (1B). This deduction is over and above the ceiling limit of Rs 1.5 lacs provided under Section 80C.
- Contribution from the employer up to 10% of Basic Salary + Dearness Allowance is also eligible for deduction under Section 80CCD(2). There is no upper cap (in terms of amount) on this tax deduction. This deduction is over and above the ceiling limit of Rs 1.5 lacs provided under Section 80C. However, this benefit is available to employees. Self-employed cannot avail this deduction.
You can see the push from the Government to attract investors to NPS. Deduction of Rs 50,000 under 80CCD (1B) is exclusive to NPS investments and cannot be availed through any other investment. Therefore a maximum of Rs 2 lacs can be claimed as deduction for own investment in NPS. Tax benefit on employer contribution is in excess of aforesaid benefit of Rs 2 lacs.
As far NPS tax benefits (on investment) are concerned, there is little confusion or discomfort. The problem lies with the tax treatment on maturity.
Tax treatment on Maturity or Withdrawal
NPS taxation on withdrawal or maturity is a grey area, atleast for me. Since the retirement of first generation of NPS subscribers is a long time away, I do not see much clarification coming from the income tax department soon.
As per my understanding of IT section 80CCD, the tax treatment of NPS withdrawals shall be as follows:
1. Withdrawal on retirement:
At least 40% of the accumulated wealth in the NPS account needs to be utilized for purchase of annuity/pension. Remaining 60% can be withdrawn as lump sum. Lump sum withdrawal will be taxed in the year of withdrawal at per investor’s income tax slab. Annuity income in the subsequent years will be taxed too.
Update: Feb 29, 2016
Under the latest budget proposal, the Finance Minister has proposed income tax exemption for 40% of the NPS maturity amount. Read this post for greater details. This sweetens the deal for NPS investors.
2. Pre-mature exit from NPS (Exit before Retirement)
At least 80% of the accumulated wealth in the NPS account needs to be utilized for purchase of annuity/pension. Tax treatment is same as on withdrawal on retirement. Both lump sum withdrawal and annuity income will be taxed.
3. Partial Withdrawal from NPS (without exiting the NPS)
Under the revised exit and withdrawal rules for NPS, limited partial withdrawal from NPS is permitted subject to certain conditions. I am not very sure about tax treatment of such partial withdrawals since this is a new change in NPS and could not find anything under 80CCD or Section 10 to form a view on its tax treatment. In my opinion, to keep parity with other withdrawals from NPS, partial withdrawal shall be taxed in the year of withdrawal as per subscriber’s income tax slab.
4. Withdrawal in the event of death of subscriber
In the event of death of the subscriber, the nominee can withdraw the accumulated corpus (in case of corporate sector NPS or self-employed). The nominee can opt for annuity payouts too. In case of government sector NPS, purchase of annuity (at least 80%) is mandatory and remaining can be taken as lump sum. As I understand, both the lump sum amount and annuity payments will be taxed as per nominee’s income tax slab. (could not find any clause that provided exemption to such income. Section 10 (10D) refers to only life insurance policies). This is in contrast to what I had written in my earlier post. If you have a different opinion, please let me know in the comments section.
Alternate view on Taxation of Lump sum withdrawals
I read an article by Manoj Nagpal, CEO, Outlook Asia Capital, in ET Wealth in March, 2015 where he highlighted a part of Income Tax Act (Section 10 (10A)), which offers some relief to subscribers on lump sum withdrawals on retirement. You can read the original article here.
Commuted pension amount refers to lump sum withdrawal on retirement.
If Section 10 (10A) applies to NPS, commuted pension (lump sum withdrawal) is tax-free for Government employees.
For private sector employees, in case the employee gets gratuity, one-third of commuted pension (lump sum withdrawal) will be tax-free. On the other hand, if the employee does not get gratuity, one-half of the commuted pension will be tax-free. If you are self-employed and have subscribed to NPS on your own, no such tax benefit shall be available.
So, if Section 10 (10A) applies to NPS, there is no parity in taxation on NPS lump sum withdrawals and depends on nature of your employment.
Please understand there is a big “If”. I am not sure whether Section 10 (10A) applies to NPS or not.
Some have advocated that NPS withdrawals should be eligible for indexation benefits (similar to one you get in debt funds or real estate) However, for that to happen, income on NPS funds has to be treated as capital gains. There is no provision in the Income Tax Act on this front.
PersonalFinancePlan Take
As pointed out before, retirement of first generation of NPS subscribers is quite some time away. So, you cannot expect clarification from Income Tax department, unless of course Income Tax department choose to be pro-active. Better clarity will emerge when people start retiring and there are litigations on this issue.
Tax considerations alone should not drive an investment decision. However, these do play a critical part. NPS, to me, is an excellent product and can be a real boon for subscribers in India where penetration of financial products is quite low. However, given its tax treatment vis-a-vis other financial products, it seems you can do better without NPS. I have expressed my reservations on NPS in an earlier post.
Taxation is a policy decision and can change. NPS may face a better tax regime. Or long term capital gains on equity funds may start getting taxed after 10-15 years. Taxation on debt mutual funds was changed last year. However, I can not speculate how tax policy will take shape. Under the present tax regime, as I understand, NPS withdrawals will be taxed at investor’s marginal rate. If you are going to get taxed on the entire NPS accumulated amount, it does not really matter whether you pay the tax now or 30 years later. It is mathematical construct.
For instance, suppose you have Rs 1 lac(taxable income). You pay 30% tax and invest the remaining amount (Rs 70,000). If the amount grows at 10% p.a. for 30 years, you will get Rs 12.21 lacs at the end of 30 years. On the other hand, if you invest Rs 1 lac in NPS today (save Rs 30,000 in taxes), the amount will grow to Rs 17.44 lacs. After you adjust for 30% tax, you are left with Rs 12.21 lacs. So, if the tax has to be paid, it does not matter when you pay tax.
There is an additional problem. You may be in a lower tax bracket now but when you make the lump sum withdrawal on retirement, you might fall in the highest tax bracket.
On a different tangent
On recommendation of Bajpai committee, PFRDA has made changes to NPS. The greatest strength of NPS was its low cost (due to passive index investing). However, since PFRDA has allowed active management, low cost structure will no longer sustain. Hence, in my opinion, NPS’s greatest strength has been compromised.
You can argue that active management will give better results (and that comes at a cost). Yes, that has been the experience in our country till now. You cannot say the same in developed countries. To be honest, there is nothing wrong with active management. But, if you are looking for active management, you can simply invest in mutual funds. In my opinion, NPS should have been left the way it was (at least as far as index investing was concerned), a low cost product.
NPS (or for that matter any financial product) cannot be everything to everyone. A lot of investor money has been lost trying to find one-size-fits-all solutions. Investment-cum-insurance products (especially traditional insurance) plans are a case in point. Unfortunately, our regulators are always in search of one.
What is your opinion on taxation of NPS? Do let me know in the comments section. I will keep making changes to this post as I get more clarity on taxation on NPS.
Disclaimer: I am not a tax expert. The analysis is based on my interpretation of Income Tax Act.
Deepesh is a SEBI registered Investment Adviser and Founder, www.PersonalFinancePlan.in