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NPS Tax Benefit explained with Examples – Updated for 2019

Investment in NPS Tier 1 account enjoys tax benefits under Sections 80CCD (1), Section 80CCD (2) and Section 80CCD(1B) of the Income Tax Act. Two of these tax exemptions – on employer contribution under Section 80CCD(1) and on an investment of up to Rs 50,000 under Section 80CCD(1B) – are additional benefits available only for NPS Tier 1. Withdrawals from NPS are governed by the Clause 12A of Section 10. After recent changes in December 2018, NPS withdrawals (under certain conditions) are tax free. This now makes NPS tax status as EEE (Exempt-Exempt-Exempt). In this post, we illustrate how you can benefit from NPS Tier 1 tax exemptions using examples. We also include the process of claiming NPS tax deduction.

In the past NPS Tier 2 accounts did not have any tax benefit. However, recently some tax rebate has been introduced but only for Central Government employees. We also discuss these.

Unless otherwise specified, these rules are most applicable to the All Citizens model.

NPS Tax Benefit 2019-2020

As the introductory paragraph makes clear, NPS tax rules are in a constant state of flux. This is to be expected of a relatively young scheme like the NPS where the regulations are still evolving.

Hence we are starting this article by first listing the changes to NPS tax benefit that will come into effect in 2019-2020. These changes were approved by the Union Cabinet in Dec 2018. 

Changes to NPS Tax rules approved by the Union Cabinet in 2018

  • NPS withdrawals are now tax exempt: Tax exemption on lump sum withdrawal at the time of exit has been increased to 60% from 40% earlier. Since 60% is the maximum amount that an NPS investor is allowed to withdraw as lump sum, after this change NPS withdrawals on retirement have become tax free.
  • Tax benefit on NPS Tier 2 accounts (for Central Government Employees): Contribution to NPS Tier 2 account will be eligible for tax deduction under Section 80C of Income tax act (so up to a limit of 1.5 lakhs), subject to a lock-in period of 3 years. However in this case, tax rules at the time of withdrawal are not clear.
  • Tax benefit on Employer contribution to NPS Tier 1 accounts (for Central Government Employees): Employer contribution to NPS Tier 1 account is eligible for tax deduction under Section 80CCD(2) of the Income Tax. Earlier the limit for this deduction was 10% of Employee salary (Basic + DA). But now the Central Government has enhanced its contribution to employee NPS from 10% to 14%. However it is unclear whether tax exemption will be extended to the entire 14% or remains limited to 10%.  
In the rest of the post, we detail the full set of NPS tax exemptions with these changes from 2019 included.  

NPS Tier 1 tax status is now EEE or Exempt-Exempt-Exempt

For any investment scheme, its tax status can be completely described by looking at the tax structure at 3 different times: (1) At the time of investing, (2) taxes when the returns are being earned but not withdrawn and (3) at the time of withdrawal.

NPS is an EEE investment i.e. contributions to NPS are tax exempt up to a certain limit ( the first E or Exempt), returns earned during the time when the funds are in NPS are also tax exempt ( the second E) and the final corpus is also now tax-free under certain conditions (the last “E” or Exempt). As discussed above the last E at the time of withdrawal is a recent development. Earlier the tax status of NPS used to  be EET because withdrawals were partially “T” or taxable.

We have organised this post is by discussing the tax rules in detail at each of these three stages.

NPS Tier 1 Tax Benefit at the time of Investment

Since NPS is a pension product, both employers and employees can make contributions. There are tax benefits on both of these types of contributions.

Tax exemption on employee/ self contribution to Tier 1 account

Employee or Self contribution to NPS Tier 1 are covered under two Sections of Income Tax

Under Section 80CCD(1):

  • An NPS investor can claim tax deduction up to 10% of salary (Basic + DA) under Sec 80 CCD(1) within the overall ceiling of Rs. 1.5 lakh under Sec 80 CCE.  
  • For an NRI NPS subscriber, this amount is 10% of the Gross income from Indian sources.
  • In the case of self-employed individuals, since there will be no contribution from employer, hence the limit for contribution is higher. From Budget 2017, self-employed individuals can claim tax exemption on up to 20% of their gross income (within the ceiling of 1.5 lakhs).

Under Section 80CCD(1B): 

  • This is an exclusive tax benefit available only for NPS Tier 1 investments.
  • From FY 2015-16, investors can claim additional income tax deduction, for an amount of up to Rs 50,000 invested in NPS Tier 1. This is over and above the Rs 1.5 lakh deduction which can be claimed on NPS Tier 1 investments under section 80C discussed above.  
  • This deduction is also available to NRIs
Combined under these two sections, a maximum of 2 lakhs deduction can be claimed as deduction on self contribution to NPS. 

However the fact that deduction can be claimed under two sections often leads to a common confusion. Suppose a subscriber is making a contribution to NPS then how much to recognize under Section 80CCD(1) vs. 80CCD(1B). The answer is that this division is entirely up to the subscriber. However since 80CCD(1B) is an additional benefit available only for NPS, so to maximize income tax benefit, it makes sense to first recognize deduction under this Section. Once the Rs 50,000 limit is exhausted, the remaining contribution can be recognized under Section 80CCD(1) provided it has not already been exhausted with other investments such as PPF, ELSS etc. Even mandatory employee contributions can be recognized in this way.

Tax exemption on employer (Corporate or Government) contribution

Employer contribution to NPS is exempt from Income tax under Section 80CCD(2)

The employers in this case can be both Government (Central and State) and Corporate. This deduction on employer contribution is in addition to the deduction on self contribution that we discussed earlier.

According to this Section, employer contribution up to 10% of salary (Basic +DA), without any upper limit, is eligible for deduction from income tax. 

For Central Government Employees, as we have mentioned above, the Union Cabinet has recently approved a proposal, according to which employer contribution has been increased to 14% from 10%. However the tax treatment of the additional 4% is still unclear.

In case you are wondering, the Government has also provided Corporate NPS tax benefit to encourage them to participate in this scheme and contribute to their employee accounts. The employers can treat the their contributions (up to 10% of basic plus dearness allowance) made to each employee’s NPS account as business expenses and get deduction under section 36(1)(iv)(a) of the Income Tax Act, 1961 without any upper ceiling. In addition, NPS also offers lower admin costs, lower fund management costs and lower compliance costs compared to similar superannuation schemes run by life insurers or a self-administered superannuation scheme.

NPS tax benefit examples

The illustration below highlights the tax benefit that a corporate employee can get by investing in NPS. To quantify the additional tax benefit, we consider three cases:

Case 1: where there is no NPS deduction
Case 2: where only the employee is contributing to NPS in his personal capacity
Case 3: where the employer and the employee are both contributing to NPS

We also consider 3 salary levels in each of these cases - mainly to correspond to the three marginal income tax rates of 5%, 20% and 30%.

NPS Tax Benefit Example for Corporate Employee - Example 1

NPS Tax benefit illustration vs. no investment case
Consider the case of a person earning salary of 10 lakhs (Basic + Dearness allowance + Other Allowances). In the case, where the person is not making any tax saving investment at all, they pay a tax of 1,12,500 Rs ( 12,500 +20% of income above 5 lakhs). This does not include surcharge or cess. If the same person invests in NPS in personal capacity they can get tax deduction under Section 80CCD (1) and Section 80CCD(1B) amounting to a maximum deduction of 1.3 lakhs. Given that the marginal tax rate for this person is 20%, this leads to a tax saving of Rs. 26,000. With an additional component of employer contribution, total deduction goes up to 2.1 lakhs and tax saving goes up to Rs 42,000 over the no investment case.

Some may argue that the above example overestimates the tax saving potential of NPS since the deduction under Section 80CCD (1) comes under the overall umbrella of Section 80C. An investor can avail of this 1.5 lakhs deduction via other investments also.  To address this we consider an example below where the investor is fully utilizing the Section 80C limit in all cases. And hence we can focus on the additional tax saving that NPS can bring via Section 80CCD(1B) and Section 80CCD(2).

NPS Tax Benefit Example for Corporate Employee - Example 2

Additional NPS Tax benefit illustration vs. only 80C investment

NPS Tax Benefit Example for Self-Employed Individual

NPS tax benefit example for self-employed individual is very similar to the case of "only employee contribution" for Corporate employees. While it is true that a self-employed individual can contribute 20% of gross income to NPS tax-free (as opposed to 10% for corporate employee), the 1.5 lakh ceiling will be the limiting factor in most cases. So the additional benefit of NPS over and above Section 80C is limited to Rs  50,000.

Proof to claim NPS tax benefit

An NPS investor can submit the Transaction Statement as an investment proof for tax purposes. All NPS investors receive a physical Transaction Statement on a yearly basis. Also, year-wise Transaction Statement can also be obtained through Call Centre/Interactive Voice Response System (IVR) using T-Pin. However the easiest way to obtain the Transaction Statement anytime is by logging in to your NPS account online using the I-Pin.

Alternatively, investors can also download the receipt of voluntary contribution made in Tier I account for the required financial year from NPS account log-in using their I-Pin. It can be downloaded from the sub menu "Statement of Voluntary Contribution under National Pension System (NPS)" available under main menu "View" in NPS account log-in.

Tax Treatment of NPS  Tier 1 returns (before withdrawal)

The structure of the NPS product is such that any returns earned on your investment corpus are completely tax-free as long as they stay within NPS and are not withdrawn. This places NPS at a tax advantage compared to mutual funds when it comes to switching asset allocation, switching fund manager and/or rebalancing. 

To explain, NPS currently offers subscribers the option to invest in 4 asset classes: Equities (E), Corporate Debt (C), Government Securities (G) and Alternative Investment Funds (A). In addition there are multiple Pension Fund Managers with Funds in these categories. At present there are 8 pension fund managers which have been approved by the PFRDA. NPS allows you to switch asset allocation two times in a year and change Pension Fund Manager once in a year. Also NPS has the feature of automatic rebalancing once every year on the date of birth of the subscriber. What that means is that NPS automatically buys and sells units of different funds once every year to make sure that you are at your desired asset allocation in line with sound finance. 

If one were to replicate the same transactions using mutual funds there would be tax and exit load implications, placing NPS at a tax advantage.

NPS Tier 1 Taxation at Withdrawal

We had earlier posted in detail about NPS withdrawal rules. In this post we will specifically recap only the tax-related rules. Withdrawals from NPS are governed by the Clause 12A of Section 10 of the Act.

Tax rules for NPS exit (Normal or Premature)

NPS exit refers to complete withdrawal from the scheme and closure of account. NPS exit can be normal (at retirement/superannuation) or premature (before retirement/superannuation). In both these cases, the same tax rules are applicable but the effect can be slightly different.

To explain, the following tax rules are applicable:
  • Tax on NPS Lump sum withdrawals: Lumpsum withdrawals from NPS are tax-free up to an amount of 60% of the total corpus. This limit earlier used to be 40% but after the recent Union cabinet approvals it has been increased to 60%.
  • Tax on NPS Annuity withdrawals: The amount allocated for Annuity purchase can be withdrawn tax free, however annuity income in subsequent years is added to the income of the subscriber and taxed at the applicable slab rate.
Effect on Normal exit: At the time of normal exit, according to withdrawal rules, a subscriber can only withdraw maximum 60% as lump sum/has to withdraw minimum 40% as annuity. When combined with the tax rules this means that irrespective of the lumpsum-annuity ratio that a subscriber chooses,their withdrawal will always be tax exempt. This is why we say, that under the new rules NPS withdrawals have become tax-exempt. Of course the annuity income will be taxed in subsequent years but that is tax on the annuity product and not NPS.
If the corpus is less that Rs 2 lakhs in the case of normal exit, then NPS withdrawal rules permit a subscriber to withdraw the entire amount as lump sum. However in this cases, given the tax rule only 60% of the amount will have a tax benefit. The remaining 40% will be taxed.

Effect on Premature exit: At the time of premature exit, according to withdrawal rules, a subscriber can only withdraw maximum 20% as lump sum/has to withdraw minimum 80% as annuity. Since this is less than the 60% lump sum limit, therefore this means that that again irrespective of the lump sum-annuity ratio that a subscriber chooses, their withdrawal will always be tax exempt.


If the corpus is less that Rs 1 lakh in the case of premature exit, then NPS withdrawal rules permit a subscriber to withdraw the entire amount as lump sum. However in this cases, given the tax rule only 60% of the amount will have a tax benefit. The remaining 40% will be taxed.

Tax rules for partial withdrawal

Partial withdrawals i.e. withdrawal of a part of the corpus without closing the NPS account is only allowed under certain conditions. Under these conditions, NPS partial withdrawals are tax-free. You can know more about these conditions in detail from our withdrawal rules post.

Tax rules applicable on nominee in event of death of a subscriber 

In the event of death of the subscriber, any lump sum withdrawal by the nominee is free from tax. 
Nominee in NPS always have the option of purchasing any of the annuity options if they so wish. In certain cases, we have discussed in the withdrawal rules post, they are mandatorily required to purchase annuities. In these cases the nominee can withdraw the annuity corpus tax free but the annuity income in subsequent years will be added to the income of the nominee and be taxed at the applicable tax slab rate.

NPS Tier 2 tax benefit

  • While investing: For most of NPS subscribers, there is no tax benefit while investing in NPS Tier 2 account. 
  • During the investment period: As with NPS Tier 1 account, there is no tax while funds are still invested in NPS Tier 2 account. This means that the investor is able to do transactions such as changing asset allocation ( twice every year), changing Pension Fund Manager (once per year) and rebalancing (one every year) without incurring any taxes that they would have to incur with mutual funds.
  • At the time of withdrawal:  NPS Tier 2 withdrawals are taxable but there is some ambiguity on how Tier 2 withdrawals are taxed. For instance, some experts believe that the whole corpus will be taxed on withdrawal vs. some who believe that only the returns/capital gains will be taxed. Similarly there is confusion on whether NPS Tier 2 returns will be taxed component-wise i.e. equity PFs in Tier 2 will be taxed like equities/equity mutual funds etc. According to us the most likely taxation is that only the returns on NPS Tier2 account will be taxed at withdrawal based on the income tax slab of the subscriber (like for FD). As we have said before, this ambiguity is one of the reasons for the low AUM in NPS Tier 2 accounts and as such we do not recommend investing in NPS Tier 2 till  this ambiguity is sorted.
The only (recent) exception to these rules is the tax treatment of Tier 2 accounts in the case of Central Government employees. As we mentioned at the beginning of this post, contribution of Central Government Employees to NPS Tier 2 account are now eligible for income tax deduction under Section 80C (so up to a limit of 1.5 lakhs), subject to a lock-in period of 3 years.  The tax status of NPS withdrawal in this case is not yet clear.

Conclusion

This blog post discussed the tax benefit on NPS Tier1 and Tier 2 accounts in 2019-20 with illustrations. NPS Tier 1 account now has several attractive features (1) NPS Tier 1 contributions can be deducted from income tax with some of these deductions in income tax being exclusive to NPS (2) It now has EEE status and (3) Additional corporate tax benefit also make it an attractive scheme for corporate to introduce in their organizations. According to us, together with other reasons (which we plan to discuss in a future post), these tax benefits make a strong case for why you should invest in NPS Tier 1 account. NPS Tier 2 tax exemption on the other hand leaves much to be desired and more clarity around NPS Tier 2 tax rules is needed.

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