NPS can help you save taxes

This year’s budget cheered the employees whose employers have covered them under the New Pension Scheme/National Pension System (NPS).

These employees are now able to save more taxes in relation to the contributions made by their employers. Government of India introduced the NPS for its employees in 2004 which was later extended to all citizens of India on a voluntary basis with effect from May 1, 2009.

Even self-employed individuals can participate in the NPS. This article explains the key features of NPS and related tax benefits which an individual can avail by participating in NPS.

Key features
NPS is a defined contribution scheme regulated by an independent regulator called Pension Fund Regulatory and Development Authority (PFRDA). This scheme is available to the citizens of India (including NRIs) in the age group of 18 to 60 years.

It provides an active choice option to the participants wherein they can decide the manner in which their NPS money is to be invested i.e.  in equity market instruments/fixed income instruments/government securities.

Though participants can decide to invest 100% of their NPS money in fixed income instruments and government securities, investment in equity market instruments are restricted up to 50%. There is an ‘auto choice’ option available for participants who are not equipped with the required knowledge to manage their NPS investments.

Under this option, the NPS money is invested in equity market instruments, fixed income instruments and government securities under a pre-defined portfolio depending on the age of the participant.

The NPS follows two types of accounts — Tier-1 and Tier-2 accounts. Withdrawals are not permitted from Tier-1 accounts during the vesting period except as per the norms prescribed by the PFRDA. There are no restrictions on withdrawals from Tier-2 accounts.

An individual can open either a Tier-1 account or both. But Tier-2 account can be opened only if the subscriber already has a Tier-1 account. The most notable feature of the NPS is the flexibility provided to the participants in respect of contributions made to these accounts.

The minimum contribution for Tier-1 account is ¤6,000 per annum which can be contributed in as many installments as per the subscriber’s choice with a minimum amount of Rs500. The Tier-2 account can be opened with a contribution of Rs1,000 and the subscriber can make as many contributions of a minimum of Rs250, provided the minimum balance in the account should not be less than Rs2,000 at the end of every financial year. In case the subscriber fails to maintain the minimum balance in Tier-2 account, a nominal penalty of Rs100 will be levied for the same.

Taxation aspects
An individual is eligible to avail deduction under Section 80CCD (1) of the Income Tax Act, 1961, in relation to the contribution made by him/her to the NPS. However, contributions eligible for deduction are limited to 10% of the salary, in the case of employed individuals and 10% of gross total income in the case of other individuals. Further, deduction under Section 80CCD(1) together with deduction for specified investments under Section 80C and deduction for pension premiums under section 80CCC is  capped up to a maximum of Rs100,000.

In the case of employed individuals, whose employers are contributing to the NPS, such contributions are first added to the salary of the employee and then deduction is allowed up to 10% of salary under Section 80CCD (2) of the Act.

Until March 31 2011, both employees’ and employers’ contributions to the NPS were covered under the overall deduction limit of Rs100,000. But with effect from April 1, 2011, employers’ contribution as eligible for deduction under 80CCD (2) will be excluded from the overall limit of Rs100,000, thereby providing additional tax savings.

This indeed is a welcome step and would encourage employers to extend the NPS benefit to its employees. It is worthwhile to note that similar beneficial provisions are also contained in the proposed Direct Taxes Code (DTC) which is expected to be implemented from April 1, 2012.

There is no comprehensive social security system in India as is available in developed countries. NPS provides an opportunity to the growing working class and self employed individuals to arrange and provide for their old age requirements.

Kuldip Kumar is executive director-Tax & Regulatory Services, PwC India.
With inputs from Vikas Kumar, PwC India