NPS and Tax: Deduction on Contribution and Exemption on Withdrawal
National Pension System or NPS saves tax along with the retirement saving. The government has given enough tax incentive to promote this scheme. However, all the NPS tax benefit is available to NPS tier-1 account. The NPS tier – 2 account gives tax benefit only to the central government employees.
You might know that, there are two types of NPS account. NPS tier-1 is a basic account. It has many condition and withdrawal is very difficult. On the other hand NPS tier-2 account can be opened only after the tier-1 account. In this account. You can deposit and withdraw money any time just like a mutual fund scheme. But if you are taking tax benefit, there would be a lock-in for 3 years.
Main Points of NPS Tax Saving
- It saves tax under section 80C. Like PPF, ELSS , the investment in NPS is eligible for tax deduction.
- The employer’s contribution in your NPS account is also exempted from tax.
- Unlike PPF, ELSS and other deductions, NPS gives you the opportunity to claim extra tax deduction up to ₹50,000. This deduction is given for voluntary NPS contribution.
- The investment in NPS is eligible for tax deduction over and above the 80C limit.
- After the age of 60, you can withdraw 60% of the balance tax-free. Rest of the amount should be used for Annuity.
- The annuity gives your regular pension, which may be taxable if annual annuity exceeds the tax-free limit.
- You can withdraw prematurely up to 25% without paying any tax.
- NPS tier 2 account does not enjoy any tax concession. Rather, Withdrawal amount would be fully taxable. Whereas mutual funds give benefit of indexation or zero long term gains tax.
NPS Tax benefits
Three are various tax benefits of the NPS investment. I will discuss them one by one.
1. Tax Deduction on NPS Contribution – section 80CCD(1)
You can save tax by investing in National Pension System. The NPS tax benefit is similar to PPF and ELSS investment. The amount you invest in NPS, gets deducted from your taxable income. That is why NPS is also eligible for tax deduction under section 80C.
However, this tax deduction is available under some conditions. The NPS Tax Benefit investment is available up to a limit.
10% of the salary
For a salaried person, the tax deduction is available up to 10% of annual salary (basic + DA). The excess investment is not eligible for tax deduction. That is why your employer deducts only 10% of salary for the NPS. You can increase it but the tax benefit would be limited to 10% of the salary.
20% of the income
There is a higher limit for a self-employed person. Such person can enjoy NPS tax deduction up to 20% of gross income. This benefit is given because a self-employed don’t get tax benefit on employer’s contribution. I would tell you later that salaried person also gets tax benefit on employer’s contribution.
You might also know that there is a limit for section 80C deduction. Your tax deduction can’t exceed this limit. As of now, this limit is 1.5 lakhs. Thus, you can claim a tax deduction up to ₹1.5 lakhs. It does not matter whether you have invested 2 lakhs or 3 lakhs. However, You get relaxation in this limit for investing in NPS. I would talk it later.
2. Tax Exemption on Employer Contribution – Section 80 CCD (2)
There is extra NPS tax benefit if the employer also contributes into your NPS account. The employer’s contribution into the employee NPS account is exempt from tax. Such contribution is not added with the taxable income of the employee. Rather, it is considered as the expense of the company.
The tax exemption on employer’s contribution is available up to 10% of the employee’s salary. Any excess amount would be taxable for the employee. However, the limit is 14% for the central government contribution.
Thus, along with employee and employer contribution, NPS makes 20% of your income tax-free. As you have seen, a self-employed also gets the chance of tax saving on 20% of its income.
NPS also gives you an opportunity to save extra tax. The NPS investment gets an extra tax deduction of ₹50,000. Because of this extra deduction, NPS tax benefit increases by 15,450.
In fact, The investment into NPS account pushes up your 80C limit. If you invest 30 thousand in NPS, your 80C tax deduction limit goes up to 1.8 lakhs (1,50,000 + 30,000). Along with NPS, you would be eligible for tax deduction up to 2.0 lakhs. Note, the extra deduction of 50,000 would be available only for the voluntary NPS investment. The regular deduction by the government is not eligible for this extra tax deduction.
This extra tax deduction to NPS is available under section 80CCD (1B). There would be a separate field in ITR form to mention NPS investment. You must quote NPS investment separately into the given cell. You can enter up to 50,000 in this cell. If there is any extra investment in NPS, club it along with other investments of section 80C(e. g. PPF, insurance, ELSS, tuition fees etc).
Tax on NPS Redemption
Till now, I have discussed the NPS tax benefit on deposit. Now, I would elaborate about the tax treatment of NPS withdrawal. You get back NPS amount in 5 ways.
- A lumpsum amount on Maturity
- Regular monthly income from Annuity scheme
- Partial withdrawal before the maturity.
- Premature closure of NPS account
- On the Event of subscriber’s death
All these 5 types of redemption has different tax rules
1. Tax Exemption on NPS Maturity Amount
After the age of 60 years, your NPS account matures. At that time you would be able to get back your NPS corpus. From whole NPS corpus, you have to take annuity using at least 40% of the amount. You can even use full amount for the annuity. As you might know that an annuity scheme gives you regular income just like a pension.
You can take remaining amount as a lump sum payment. The government does not charge any tax on this lump sum payment. Earlier this exemption was available upto the 40% of the amount,. But now the government has given the exemption on complete withdrawal amount which can go upto 60%.
2. Tax on Annuity Income
We know that annuity of 40% corpus is mandatory. This annuity gives monthly pension up to a specified period. Is this regular annuity payment tax-free?
There is no special tax exemption on annuity income or pension. Rather, it is considered as normal salary income. Hence, It would be eligible for prevailing limit of tax-free income. Suppose, you are earning 25,000 per month as an annuity payment. This would translate into 3 lakhs in a year. We know that according to current income tax slab, income up to ₹3 lakh is tax-free for senior citizens. Thus, there would be a tax on this annuity payment.
Whereas, if annual annuity payment would have been 4 lakh, there would be a tax liability. However, there are many other ways to save taxes. Most of the people use such methods to reduce tax. Note, The limit of tax-free income keep increasing with the time.
3. NPS Tax Benefit on Partial Withdrawal
NPS allows you to withdraw some amount before the maturity. This withdrawal should be for some specified reason. These reasons are higher education, children marriage, home purchase etc.
However, partial NPS withdrawal is limited to the 25% of the self-contribution. The employer’s contribution is not considered for partial withdrawal.
This partial withdrawal is also tax-free. The clause 12B of section 10 of the income tax give exemption up to 25% of self-contribution.
4. Tax on Premature Closure
NPS also gives the option to exit scheme before the retirement or 60 years age. However, In such case, you have to use 80% of the amount of annuity. You can take remaining 20% as a lump sum. There would not be any tax on the 20% lump sum amount.
5. Withdrawal in the Event of subscriber’s Death
If a subscriber dies the nominee of the NPS account can withdraw whole amount taxfree. If the nominee wishes, It can also take annuity scheme. However, annuity payment would be taxable as per the applicable slab rate.
If the NPS subscriber is a government servant and dies before the maturity, the nominee can withdraw the whole amount. Rather, the nominee has to take annuity plan using at least 80% of the corpus. The remaining account can be taken as the lump sum.
Taxation of Tier-2 Account
The tier-2 account is liberal. By using this account, you can enjoy the low cost fund management service of the NPS fund managers. Normally, this account does not give any tax deduction and exemption. However, recently, the government has given extra benefits to the central government employees. Such employee can claim tax deduction on the tier-2 investment as well. But the claimed investment should remain in the account for 3 years. Thus the tier-2 account would be similar to the ELSS for the central government employees.
Note, there can be capital gains tax on the withdrawal of tier-2 corpus. Whereas, there is no capital gains tax on ELSS.
So, this is the complete information about the taxation of the National pension system. This pension system has become very lucrative. So, now you can opt this scheme instead of the PPF or EPF. The tax treatment of NPS has become similar to the taxation of EPF and PPF.