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On May 1, 2009, the New Pension Scheme (NPS) was thrown open to all citizens of India. Until then, the scheme was available only to central and state government employees.

Like any other pension plan, NPS helps the investor build a retirement corpus by making periodic contributions. Any Indian citizen (including an NRI) aged between 18 and 55 years can open an account under the scheme, which requires a minimum investment of Rs 500 per month or Rs 6,000 a year, so a decent corpus could be made ready by the time one hits 60. There is no upper limit.

So far, so good.

But what of tax benefits? Or of the incidence of tax on the amount at maturity?
The NPS offer document simply mentions that tax benefits would be applicable as per the Income Tax, 1961, as amended from time to time.

No specific details have been given. And while there have been several articles on different aspects of the scheme, one hasn’t heard anything on the tax side yet.
This article is about the taxes applicable to NPS. Taxes are important, since, like expenses, they tend to eat into the eventual return.

Let’s see what the Income Tax Act (ITA) has to say on the tax benefits.

Tax benefits
First, let’s take the contributions made by an investor. As per most media reports, contributions made to NPS are to be deductible under Sec. 80C. Yet others say it is not Sec. 80C but in fact Sec. 80CCD that would extend the deduction.

However, it may be noted that as of now there is no clause under Sec. 80C that specifically offers deduction in respect of contributions made to NPS. While Sec. 80C(2)(ii) offers deduction for a sum paid to keep in force a contract for a deferred annuity, the language used therein is tenuous and one cannot say with certainty whether NPS payments will be covered by this sub-clause.

While Sec. 80CCD does offer a deduction in respect of the amounts deposited under a pension scheme notified by the central government, such deduction is available only to employees (government as well as private) and that too up to a limit of 10% of the salary. This would mean self-employed and unemployed persons will not be able to take shelter under Sec. 80CCD as it stands today, even though the scheme is open to any Indian citizen in the 18-55 age bracket.

Secondly, while the minimum contribution to NPS is Rs 6,000 per annum, there is no limit on the maximum that one can invest. However, even employees who are otherwise covered through Sec. 80CCD would only be able to claim a maximum deduction of 10% of their salary even if the amount invested in NPS is higher.

Next, let’s examine the tax treatment of the maturity amount.

Tax at maturity
As per NPS rules, if withdrawal is sought earlier than age 60, 80% of the accumulated capital is to be used to buy a life annuity and the balance may be withdrawn in a lump sum. Between the ages of 60 and 70, a minimum of 40% of the pension wealth is to be used to purchase the annuity and the balance has to be withdrawn in a lump sum.

Therefore, basically, at maturity, tax incidence will have to be examined on both the lump sum as well as the annuity.

As per the existing provisions under Sec. 10(10A), read with Sec. 10(23AAB) of the ITA, any commutation of pension received under a pension scheme received from an insurance company is exempted fully. Commutation of pension is jargon for what essentially means receiving a lump sum. Therefore, simply put, any lump sum received under a pension scheme of an insurance company is fully tax-exempt.

NPS lump sums, however, are not covered under this section and hence by inference would be fully taxable. The annuity or pension payments are taxable in all cases, which means the entire income stream from NPS (the lump sum as well as the annuity) would be fully taxable for the pensioner.

This essentially makes NPS the first among the EET (Exempt-Exempt-Taxed) kind of instruments. It has been the stated intention of the government to gradually move to an EET type of taxation system from the current EEE (Exempt-Exempt-Exempt) architecture as exemplified the Public Provident Fund (PPF).

The upfront investment in PPF is tax deductible (the first E), the interest is tax-free (the second E) and the maturity amount is also fully exempted (the last E), thereby making it EEE. However, under the EET system, while the upfront investment will be reduced from your income, thereby lowering the tax liability, when the amount matures, it would be taxable in that year.

While there is no doubt that the EET system is more equitable and followed the world over, singling out only NPS for the same would be unfair and will stifle the growth of a promising instrument in its infancy.

To be fair, the other tax-saving investments like PPF, post office time deposits, insurance plans and ELSS should also be converted into EET, or the NPS also made EEE.

To sum
There is no gainsaying that the sooner the Central Board for Direct Taxes or the Ministry of Finance issues clarifications on the above tax issues, the smoother it would be for the NPS to take off.

In the meantime, those who refrain from investing fearing uncertainty on the tax front would do well to remember the words of Benjamin Franklin: “Taxes are indeed very heavy - We are taxed twice as much by our idleness. Three times as much by our pride. And four times as much by our folly.”