National Pension System– Taxation issues

Over the last few weeks, we have been discussing the various aspects of NPS – right from its overall structure, the low cost, the various annuity options that it offers and of course the inbuilt withdrawal facilities. In the concluding part of the series, this week we shall examine the tax benefits associated with NPS and arrive at a conclusion if it is indeed an investment-worthy product or not.

NPS Tax Treatment

Basically, the contributions made by an individual to his NPS are deductible u/s 80CCD. The ceiling on contribution in the case of an employee is 10% of his salary and in any other case, 10% of his gross total income. Salary includes dearness allowance if the terms of employment so provide (including arrears, if any), but excludes all other allowances and perquisites. The aggregate limit of deduction is 1` .5 lakh under the umbrella of Sec. 80CCE which engulfs Secs. 80C, 80CCC and Sec. 80CCD.

The contribution of the employer to the extent it does not exceed 10% of the employee’s salary is not taxable and it is not a part of the limit on contribution of the employee to Sec. 80C.

Additional Tax Deduction

In order to give a fillip to this Scheme, Finance Act (FA) 2015 has provided for a separate deduction u/s up to `50,000, which is independent of the `1,50,000 deduction mentioned above.

Withdrawals are taxed

However, NPS withdrawals are governed by Sec. 80CCD(3) which taxes any amount received by the assessee, including the annuity. The annuity is also taxable in the hands of the nominee who has the option to own the scheme and continue the contributions, if he is eligible to do so. Fortunately, FA16 has made 40% of the withdrawal totally tax-free. Moreover, the amount received by the nominee on the death of the assessee is not taxable. Note that the annuity however, continues to remain taxable.

So how does it stack up?

Net-net, in a country that does not have government paid social security benefits; a retirement product like NPS is an extremely useful as well as desirable savings plan for the community at large. That being said, benefits of the NPS have to be understood in their correct perspective.

First of all, realize that this was meant to be an EET (Exempt – Exempt –Taxed) kind of a product where the initial investment as well as the return on the same is exempted, however, upon withdrawal there is tax incidence. For any EET product, tax saving is not permanent, it is merely deferred till the time of withdrawal.

However, in the case of NPS, as mentioned earlier, a 40% exemption on withdrawal was brought in later as an amendment. So essentially, it is only to the extent of 40% that NPS is truly permanently tax-free. The balance 60% including any annuity that one may purchase is fully taxable. So to that extent, one can say that from the initial tax deduction, only 40% is permanent – so if one were in the 30% tax bracket, it would mean that on any NPS contribution, tax saved would be to the extent of 30% of income – only 40% of this 30% would be saved permanently. In other words, the true tax deduction on NPS is to the extent of 40% of 30% i.e. 12%.

Yet – even at 12%, it is a good tax saving product – not the least on account of the employer’s contribution. Just like in the case of PF, the employer’s contribution to NPS is over and above what one gets as salary – so not only is there a tax deduction but also more money on the table in the form of employer’s contribution (which wouldn’t have been received by the employee if he or she hadn’t invested in NPS). But here too, it has been reported that many organizations have adopted the policy of deducting the employer’s contribution from the employee’s salary itself – the employee goes for it on account of the fact that this makes the money to the extent of the employer’s contribution tax-free (else if it’s received as salary it would be taxable). We are not commenting on whether this is a fair policy or not – be that as it may – but if it is only for the tax benefit that one is investing in NPS, then be warned that the same is 12% and not 30%.

Lastly, we strongly feel that NPS being a ‘Pension Scheme’ it is possible to claim the benefit of Sec. 10(10A). Accordingly, this lump sum is tax free for government employees. For private sector employees the freedom from tax is one-third or half of the lump sum, depending upon whether the individual has received gratuity or not. This is the same tax structure as applicable to Superannuation Funds (Refer Chapter Retirement Benefits).

FA15 has also prescribed the following additional benefits —

(a) The subscribers to Employees Provident Fund (EPF) have been given an option to shift over to NPS, lock, stock and barrel.

(b) Employees covered under Employee’s State Insurance are offered the facility to shift over to any Health Insurance Product, recognised by the IRDA, thereby increasing their benefit.

(c) Employees below a certain threshold of monthly income, contribution to EPF have been made optional, though employers have to continue to contribute their 12% share for such workers.

Great news! FA16 has declared that the amount received by the nominee on the death of the assessee is not taxable.

To Sum

On the one hand is the disadvantage of taxability at withdrawals, and also of annuity pension and on the other there is the advantage of low cost. To an extent, both counterbalance each other. As mentioned early on in the article, if NPS is used as a compulsory savings tool that is meant to yield pension at the time of retirement, then yes, it is indeed a salutary product. However, astute investors who are informed and capabale of making their own choice in terms of quality mutual fund schemes and if they invest montly as one would end up doing in NPS, they would pehaps be better off investing on their own. Unfortunately, those who join government service on or after 1.4.04 have no choice.

At present EPFO manages a corpus of about `6 lakh crore with an active subscriber base of 5 crore members whereas NPS has nearly ` 75,000 crore with close to 80 lakh subscribers. It appears that the authorities are keen on reversing these numbers in due course.