2.g Retirement Benefits

Retirement and Taxation in India

Retirement is a significant life event, symbolizing the transition from a working career to a life of leisure. It’s a phase eagerly anticipated by many, offering a well-deserved respite from work. However, this transition requires careful financial planning to guarantee a secure and comfortable future. Crucial to this planning is understanding how retirement benefits are taxed in India. Retirement benefits encompass Gratuity, Pensions, Leave Encashment, Provident Funds, the National Pension System (NPS), and more. The tax implications of these benefits can significantly impact retirees’ financial well-being, making it imperative to comprehend their treatment.

Taxability of Retirement Benefits

Retirement benefits play a crucial role in providing financial security to employees in their post-retirement years. In India, employers provide various retirement benefits to employees. The most common retirement benefits offered by employers in India include the Employee Provident Fund (EPF) and the National Pension System (NPS), both of which are savings schemes that allow employees to accumulate a portion of their salary, along with a matching contribution from their employer. Additionally, employees are entitled to receive gratuity, a lump sum payment made as a token of appreciation for their service, and leave encashment on their retirement. If an employee is eligible for a pension, they may also receive a commuted pension. If an employee is voluntarily retired or retrenched, they may be entitled to voluntary retirement compensation or retrenchment compensation. The taxability of these retirement benefits under the Income-tax Act is as follows:

Gratuity

An employer is liable to pay gratuity to an employee who has completed 5 years of continuous service and whose employment with the employer terminates due to retirement, resignation, or superannuation. However, in the case of the death or disablement of the employee, the employer is liable to pay the gratuity even if the employee does not complete 5 years of service. The taxability of gratuity shall be as follows:

Pension

Pension is a payment made by the employer after the retirement/death of the employee as a reward for past services. There are two kinds of pensions:

1. Commuted Pension – Commutation of pension means immediate payment of the lump-sum amount to an employee in lieu of surrendering a portion of the monthly pension.
2. Uncommuted Pension – When the pension is paid on a periodical basis, it is called an uncommuted Pension.

The tax treatment of pension shall be as follows:

Leave Encashment Salary

Every entity provides leaves to the employees, which can be availed of by them in emergency situations or for vacations. If these leaves are not availed of by them, they may lapse or be encashed at the year-end or carried forward to the next year, as per the service rules of the employer. The accumulated leaves standing to the credit of an employee may be availed of by the employee during the tenure of employment or may be encashed at the time of retirement or resignation. When leaves are surrendered in lieu of monetary consideration, it is known as ‘leave encashment’. The taxability of leave encashment shall be as follows:

Voluntary Retirement Scheme

Voluntary retirement is an early retirement option given by an employer to its employees to take retirement before the decided age of retirement. To ensure social security for the retiring employees, employers provide ‘voluntary retirement compensation’ to their employees. Such compensation is taxable in the hands of the employees as profit in lieu of salary. However, exemption under Section 10(10C) is allowed to the extent of the lower of the following:

• Compensation received; or
• ₹500,000.

The exemption is allowed subject to the following conditions:

• The voluntary retirement compensation is paid by the specified category of employer.
• The scheme should be drawn to result in an overall reduction in the existing strength of the employees.
• The employee has completed 10 years of service or completed 40 years of age. (This condition is not applicable in the case of employees of a Public Sector Company).
• The vacancy caused by the voluntary retirement is not re-filled by any other new hiring.
• Moreover, the retiring employee must not be employed in any other company or concern of the same management.
• The employee has not availed of any tax exemption in respect of voluntary retirement compensation in the past.
• The amount of compensation does not exceed 3 months’ salary for each completed year of service or salary for the remaining period of employment left before such retirement.
• ‘Salary’ for this purpose shall be the total of the last drawn basic salary, dearness allowance (if it forms part of salary for computing retirement benefits), and commission paid to the employee.
• The scheme should apply to all employees, including workers and executives of a concern, excluding directors of a company or a co-operative society.
• The employee should not claim relief under Section 89 in respect of such compensation.

Retrenchment Compensation

Retrenchment Compensation received by a workman under the Industrial Dispute Act, 1947, or any other law for termination of his employment is exempt from tax up to ₹500,000.

Provident Fund

Employee’s Provident Fund (EPF) is a retirement benefit scheme that’s available to salaried employees. Contribution in EPF is made both by the employee and the employer. The contribution, earnings, and withdrawals from the EPF account are exempt from tax except in certain circumstances. The tax treatment in respect of contributions made to and payments from various provident funds is summarized in the table given below:

National Pension System (NPS)

National Pension System (NPS) is a retirement savings scheme administered and regulated by the Pension Fund Regulatory and Development Authority (PFRDA). Under the NPS, individual savings are pooled into a pension fund which is invested by PFRDA-regulated professional fund managers as per the approved investment guidelines into the diversified portfolios comprising government bonds, bills, corporate debentures, and shares. These contributions would grow and accumulate over the years, depending on the returns earned on the investments made. The tax treatment of the contribution made to the NPS, accumulation of returns, and the amount withdrawn from the NPS.

Tax Treatment of Contributions to the NPS, Accumulation of Returns, and Withdrawals from the NPS

1. Contribution to NPS

• Employee’s Contribution:
• Contributions made by an individual employee to their NPS account are eligible for tax deduction under Section 80CCD(1) of the Income Tax Act.
• This deduction is part of the overall limit of ₹1.5 lakh under Section 80C.

• Additionally, a further deduction of up to ₹50,000 is available under Section 80CCD(1B) for contributions made to the NPS. This additional deduction is over and above the ₹1.5 lakh limit under Section 80C.

• Employer’s Contribution:

• Contributions made by the employer to the NPS account of an employee are eligible for tax deduction under Section 80CCD(2).
• The deduction is limited to the lower of:
  • The actual amount contributed by the employer.
  • 10% of the employee's salary (basic salary + dearness allowance).
• There is no monetary limit on this deduction, and it does not form part of the ₹1.5 lakh limit under Section 80C.

2. Accumulation of Returns

• The returns earned on the accumulated NPS contributions are not taxed annually.
• The NPS follows the EEE (Exempt-Exempt-Exempt) tax regime, meaning:
• Contributions are tax-exempt.
• Accumulated returns are tax-exempt.
• The final corpus is tax-exempt under certain conditions.

3. Withdrawals from NPS

• Partial Withdrawals:
• Partial withdrawals from the NPS are allowed under certain conditions and are exempt from tax.

• An individual can withdraw up to 25% of their own contribution before retirement without incurring any tax liability.

• Withdrawal at Retirement:

• At the time of retirement (on reaching 60 years of age), an individual is required to use at least 40% of the accumulated corpus to purchase an annuity (which provides a regular pension), and this 40% portion is exempt from tax.

• The remaining 60% of the corpus can be withdrawn as a lump sum. As per the latest tax laws, this lump sum withdrawal is also exempt from tax.

• Withdrawal before Retirement:

• If an individual exits the NPS before reaching the age of 60, they are required to use at least 80% of the accumulated corpus to purchase an annuity, and this portion is exempt from tax.
• The remaining 20% can be withdrawn as a lump sum, which is also exempt from tax.

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