During our working life, we get used to receiving salary credit in our bank accounts. After retirement, this routine can come to an abrupt halt. Many government employees who have been contributing to their Defined Benefit Pension plan can still heave a sigh of relief. For others, they need to figure out a way to stick to the routine.
It is not that you cannot do without regular salary credits to your bank account. It is just that you are used to getting a fixed income at the end of the month and using that income to meet your monthly expenses. You have been doing the same thing over the last 35-40 years. As they say, habits die hard.
This is where pension plans from insurance companies can come in handy.
By purchasing pension plans, you ensure that you continue to receive monthly income even during your retirement.
Do note pension plans from insurance companies are not the only pension schemes around. There are many more. NPS (New pension scheme) is a prime example. In addition, there are defined benefit schemes from many employers. The tax treatment (especially the commuted pension) for various pension plans varies significantly.
In this post, I will focus only on the tax benefits on investment in pension plans from insurance companies and the tax treatment of monthly (periodic) income from such plans.
Read: PFP Primer: Pension Plans from Insurance Companies
How does a pension plan work?
A pension plan can be divided into two phases viz. accumulation and distribution. Under the Accumulation phase, you contribute to your pension corpus during your working years. Your pension corpus keeps growing over a period of time.
Post-retirement, you enter the distribution phase and receive payment from the pension plan. To receive monthly income, you purchase an annuity plan using full or part of the accumulated pension corpus. In the distribution phase, you do not need to make any further payments to the insurance company.
Though it is not mandatory, the accumulation phase typically goes on till retirement and distribution phase begins after retirement. By the way, nobody stops you from purchasing a pension plan that starts paying you after 5 years while your retirement is still 20 years away. It is your choice.
Additionally, it is not that you must get a monthly income only. Annuity plans allow you to draw quarterly or annual income too.
Tax Benefits on Investment in Pension Plans
Investment in a pension plan from an insurance company is eligible for deduction up to a maximum of Rs 1.5 lacs per financial year under Section 80 CCC of the Income Tax Act.
The tax benefit under Section 80CCC is NOT over and above Section 80C tax benefit of Rs 1.5 lacs per financial year.
Note: As per Section 80CCE of the Income Tax Act, the aggregate amount of tax benefit under Section 80C, Section 80CCC and Section 80CCD (1) is capped at Rs 1.5 lacs per financial year.
Tax Treatment at Maturity of the Pension Plan
As per Section 10(10A) of the Income Tax Act, any payment received in the commutation of pension income (from a pension plan by an insurer) is exempt from tax. Commuted pension means receiving a portion of pension income as lump sum.
IRDA, the insurance regulator, has capped the commutation of pension income to one-third of the accumulated corpus. For instance, if you have accumulated Rs 1 crore in your pension plan from the insurance company, you can receive maximum Rs 33.33 lacs as lumpsum (commuted pension) while the remaining Rs 66.67 lacs shall be used to purchase an annuity plan to receive monthly (or periodic) income.
Rs 33.33 lacs received as lump sum shall be exempt from income tax under Section 10(10A) of the Income Tax Act.
Update: IRDA, in July 2019, increased the commutation of pension income to up to 60% of the accumulated corpus. Earlier, the maximum commuted amount was 1/3rd of the accumulated corpus. As we have discussed before, any commuted amount is exempt from tax as per Section 10(10A)(iii) of the Income Tax Act. This brings the pension plans from insurance companies in line with NPS. NPS allows to withdraw 60% of the accumulated corpus and such withdrawn amount is exempt from tax. As I understand, this will only apply to plans filed and purchased after the new regulations. You need to check the policy wordings to be completely sure.
Therefore, new pension plans may permit you to withdraw up to 60 % of the accumulated funds and that too tax-free.
By the way, there is no compulsion to receive 1/3rd (or 60% as the case may be) of the accumulated corpus as lumpsum. You can even choose to receive the entire corpus as monthly (periodic income).
Annuity income (monthly income) is taxed in the year of receipt at your marginal income tax rate (income tax slab).
Tax Treatment on Surrender of Pension plan
In case you surrender the pension plan, the surrender value will be added to your income for the year and taxed at the marginal income tax rate. This is as per Section 80 CCC of the Income Tax Act.
This is a minor twist with this rule (and you need to check this with your CA). The surrender value will be added to your income and taxed at a marginal rate only if you took the tax benefit under Section 80CCC of the Income Tax Act. So, no relief if you took the tax benefit under Section 80CCC. The entire surrender proceed is taxable.
If you invested but didn’t take the tax benefit under Section 80CCC for any of the years(and subsequently surrendered), you may get some relief. You can deduct the premiums paid from the surrender proceeds to arrive at the taxable portion.
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Every pension product, as pointed out earlier, will have Accumulation and Distribution phases.
The way our money skills get nurtured during our working years, it may make good sense to purchase an annuity plan. An annuity plan will provide regular income to your family. Moreover, annuity plans, if you purchase the right variant at the right age, can add a lot of value to your retirement portfolio. It can increase income and reduce longevity risk.
However, if you have enough investment discipline, you can do without a full-fledged pension plan from an insurance company i.e. you can accumulate corpus on your own by investing in different mutual funds, PPF, EPF, fixed deposits, etc. At the time of retirement (or a few years after retirement), you can simply purchase an annuity plan from an insurance company that offers you the highest annuity rate.
Pension plans from insurance companies come with many restrictions on withdrawal, exit and purchase of annuity but that’s what you expect a pension plan to do. You can avoid all such restrictions by creating pension corpus on your own by investing in mutual funds, PPF, EPF, bonds, FD etc, effectively bypassing the accumulation stage of pension plans. Subsequently, you can purchase an annuity plan based on your requirements.
Additional Read
Section 10 and Section 80CCC from the Income Tax Act
LIC Jeevan Shanti: An immediate and deferred annuity plan from LIC