The National Pension System (NPS) has been vigorously discussed in the media ever since the Budget proposed additional tax benefits. NPS allows withdrawals of up to 60% of the accumulated corpus on or after the age of 60.
Multiple theories have been floated in the past few weeks. Some say there is a possibility of withdrawals being eligible for indexation benefits. Others suggest that the rules relating to tax treatment of NPS are still ambiguous and further clarity is required. Nothing can be farther from the truth. The tax treatment on NPS withdrawals is quite simple and has been unequivocally defined in the various budgets in the past few years. One might argue that NPS tax treatment is unfair, but it is incorrect to suggest that the rules are confusing and need clarity.
The dominant retirement products in India, the EPF and PPF, offer tax exemption at all three stages: contribution, growth and withdrawals. When the NPS was designed, the direction was clearly to migrate to the EET regime where contribution and growth is tax free but withdrawals are taxable. It was made amply clear in the 2004 Budget presented by P. Chidambaram that the scheme would follow EET taxation. The Budget memorandum clarified that the entire amount in the NPS account will be treated as normal income for the individual in the year of withdrawal either as lump sum or as pension through annuity. Since all withdrawals were said to be treated as normal income, there is no question on indexation benefits being applicable.
Later budgets further clarified this by amending Section 80CCD, excluding the amount of corpus used to purchase the annuity from the tax ambit and including the words ‘whole or part’ as being taxable when received by the individual. Thus, right from the beginning it has been clear that NPS withdrawals will be treated as income with marginal tax rate applicable on the entire withdrawals.
One key aspect about the taxation of NPS needs particular attention. For government employees who contribute to the NPS, the commutation withdrawals are exempt from tax. For other investors whose employers offer the NPS, withdrawals from the scheme enjoy some tax exemptions under Section 10(10A). If an individual does not receive gratuity, up to 50% of the total corpus received as commuted pension will be tax free. If gratuity has been paid, only 33% of the corpus is tax-free.
Let us look at the tax implications for an individual who has a corpus of Rs 2 crore when he retires. Of this, 40% (or Rs 80 lakh) will go into buying an annuity. Assuming that he does not receive gratuity, 50% of the corpus (or Rs 1 crore) will be tax free. So, he will be taxed only for Rs 20 lakh. If he has received gratuity, only Rs 66 lakh will be tax free and he will be taxed for Rs 54 lakh. But savvy investors can minimize the tax by staggering the withdrawals over 4-5 years.
On the one hand, tax exemption under Section 10(10A) is positive. Even so, the tax treatment is discriminatory. Private sector employees do not get the same tax benefits as government employees. The commuted corpus has tax exemptions only for NPS offered by an employer. Under current rules, an individual who does not have a corporate NPS account but invests in the NPS directly is not eligible for the tax exemption under Section 10(10A). This makes the NPS taxation unfair to the self-employed. They don’t even get the exemption enjoyed by employees in the private and government sectors.
Mind you, NPS is by far a much superior retirement vehicle than any of the other options. But for a scheme that was primarily envisaged to bring the self-employed into the pension fold, NPS needs to offer uniform tax treatment to all participants irrespective of the nature of their employment. For this to happen, the NPS should be brought under clause 23(aab) and make the tax treatment the same for all. If this anomaly in the taxation of NPS is rectified and the tax benefits under Section 10(10A) are evenly offered to all, NPS will become the most preferred vehicle for retirement planning.