Tax Benefit on NPS Scheme – Tier 1 & Tier 2 | Is Employer Contribution to NPS Taxable?

Before learning about the Tax Benefit on NPS Scheme for Tier 1 & Tier 2 Account.
It is important that an investor knows, “What is NPS Scheme?“. Therefore, let’s start from the basics of a NPS Scheme .

Also Read National Pension System : A Complete Guide for Retirement Plan

NPS Scheme

The National Pension Scheme also called as New Pension Scheme is one of the financial products, You can use to reduce your tax outgo and also secure your retirement without any stress.

NPS is regulated by Pension Fund Regulatory Development Authority and any citizen between the age of 18 and 65 can join it,
Since, it’s a retirement plan, an investor (Tier-1 account) can’t redeem his fund before the age of 60.
However, partial withdrawal is allowed in specific needs like education, marriage etc.

The NPS comes with EEE (Exempt-Exempt-Exempt) tax status, that means
Exempt 1 – an investment qualifies for deduction & a part of the annual income, which is equal to the investment amount, is not taxable,
Exempt 2 – the income on investments is exempted, and Exempt 3 – implies withdrawal of funds from investment is tax neutral.

The Budget 2020 has proposed a New Tax Regime in addition to the existing (Old Tax Regime).
To put it simply, the assesses can select between the New Tax Regime and the Old Tax Regime depending on what is best suitable from a tax planning point of view. Later, we will discuss about Tax Benefits under the new tax regime.

NPS accounts are primarily of 2 types, Individual NPS Account & Corporate NPS Account.
The Subscribers have the option to open 2 types of NPS Accounts (Tier-1 and Tier-2) under the same Permanent Retirement Account Number (i.e. PRAN).
Although NPS Tier 1 is suitable for retirement planning, Tier 2 accounts act as a voluntary savings account. The tier 1 investment is a long-term one and the amount can’t be withdrawn until retirement. This is not the case with Tier 2 accounts.

Now that we have seen the difference between Tier 1 and Tier 2, it’s time to explore the different NPS scheme tax benefits.

Tax Benefit on NPS Scheme – Tier 1 Account

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Let us discuss tax benefits for Salaried and Non-Salaried Individuals.

NPS Tax Benefit for Salaried Individuals

Income tax-saving benefit of NPS at the of investment can be claimed under three sections of the Income-tax Act, 1961.
These sections are:
Section 80C,
Section 80CCD (2) and Section 80CCD (1B).

Also Read NPS Contribution: Online and Offline | Contribution by employer 2020-21

1. Section 80C

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Income Tax-benefit under section 80CCD (1) is available on an individual’s self-contributions.
An individual can claim tax benefit on a maximum self contribution of ₹1.5L in a financial year.
Section 80CCD (1) deduction comes under the overall limit of Sec 80C of the IT Act 1961.

The fund so deposited up to ₹1. 5 lakh can be claimed as deduction from the gross total income before tax, thereby reducing the tax liability.
Therefore, if you have deposited more than ₹1. 5 lakh in your account, then you will be able to claim tax benefit on ₹1. 5 lakh only as per Income-tax Act, 1961. But, there is no limit on the maximum amount that can be deposited in the account.

2. Section 80CCD(2)

Tax benefit under Sec 80CCD (2) can be claimed by the individual when the employer deposits the money on behalf of the individual in account.
The employer can deposit a maximum of 10% of the individual’s salary (Basic salary + Dearness allowance) as per the IT Act 1961. However, government employees can claim 14% of their salary tax deduction under this section.
One biggest question that is running through your mind now? That is – “Is Employer Contribution to NPS Taxable?

Also Read Understanding The Background of “What is Tier 1 and Tier 2 in NPS

Is Employer Contribution to NPS Taxable?

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Central Government had launched a new regulation through Finance Act 2020, effective from the FY 2020-21.
So, as per the new regulation

  • Employer contributions to NPS in each financial year, in excess of ₹7.5L shall be considered taxable in the hands of employees.
  • Any interest on the taxable contribution (in excess of ₹7.5L) would also be considered a taxable perquisite in the hands of the employee.

In view of the above formula, an example has been given below as reference:

Amount contributedTaxable amount under Section 17(1)(viii)Taxable amount under Section 17(2)(vii)Deduction under Section 80CCD (2)
Employer contributes ₹2 lakh to NPS account of employee and no contributions towards PF₹2 lakhNIL₹2 lakh
Employer contributes ₹2 lakh to NPS account of employee and ₹2.4 lakh towards PF₹2 lakhNIL₹2 lakh
Employer contributes ₹4 lakh to NPS account of employee and ₹4.8 lakh towards PF₹4 lakh₹8.8L – ₹7.5L = ₹1.3 lakh
Interest earned on ₹1.3L will be taxable
₹4 lakh
Source – economictimes

3. Section 80CCD(1B)

Additionally, an individual can claim deduction under 80CCD (1b) for a maximum of ₹50,000 in a financial year. This extra deduction was introduced in the financial year 2015-16.
The additional tax benefit of ₹50,000 is over & above tax-break under section 80CCD (1) and 80CCD (2).

Also Read NPS benefits: 12 Reasons For Investing In NPS

NPS Tax Benefit for Non-Salaried Individuals

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Non-salaried individuals (i.e. businessman, professional, housewife, etc.) may contribute up to 20% of their gross annual income in the Tier-1 Account to avail tax benefits up to ₹1. 5 lakh under section 80C.
Such individuals may also get additional tax benefits up to ₹50, 000 under section 80CCD (1B) by making a voluntary contribution to Tier 1 Account.

Now, the one important question which comes to your mind, “How much should I Invest in NPS for Tax Benefit?“.

How Much Should I Invest in NPS for Tax Benefit?

Salaried Individuals – For example a private employee’s basic salary is ₹5 lakh and another ₹1 lakh as DA. So he can claim maximum 10% of Basic + DA means ₹60,000 on his employer’s contribution.
Besides, if he/she adds the deductions under Sec 80C and Sec 80CCD (1B), he/she can claim deduction up to ₹2,60,000/-.

Basic Salary5 Lakh
Dearness allowance1 Lakh
Section 80C1.5 Lakh
Section 80 CCD(2)Maximum of 10% of the salary
(Basic salary + Dearness allowance)
60,000
Section 80 CCD(1B)50,000
Total deduction1,50,000+60000+50000 = 2,60,000/-

Non-Salaried Individuals – for example, a housewife having gross rental and interest income of ₹10L may contribute ₹2L to Tier-1 account and may claim tax benefit of ₹1.5 under section 80C and additional benefit of ₹50,000 under section 80CCD(1B).

Let us now learn tax benefit on NPS scheme for tier 2 account.

Tax Benefit on NPS Scheme – Tier 2 Account

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According to Budget 2019-20, Government employees have an choice to invest in Tier 2 account with a lower lock-in period.
A government employee can invest maximum of ₹1.5 lakh in the Tier 2 account to claim tax benefit (Section 80C of IT Act. 1961.)
Unlike lock-in period till the age of retirement, the investment made in Tier 2 account of NPS under section 80C comes with a lock-in period of 3 years.
Income tax benefit for Tier 2 account is unavailable for non-government employees.

Also Read NPS Tier 2 Returns | 2021

Let us now learn NPS contribution in new tax regime.

Which Deductions are Allowed in New Tax Regime?

If you are opting for the new tax regime for the current financial year, then NPS is only one deduction under the Income-tax Act, 1961 that can support you reduce your income tax liability.
You can claim tax benefit ₹1.5 lakh under the Section 80C.

You cannot claim addition up-to ₹50,000 tax deduction benefit under Section 80CCD of the Income Tax Act, 1961, However, it will continue under the old regime.

Let us now learn NPS withdrawal process.

Withdrawal for Tier 1 Account

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  1. Partial withdrawal
    Subscriber can partially withdraw from NPS tier I account before the age of 60 for specified purposes such as Higher education of children, marriage of children, Critical illness etc.
    According to Budget 2016-17, funds withdrawn up to 25% of Subscriber contribution is exempt from tax.
  2. Annuity purchase
    Funds invested in purchase of Annuity, is fully exempt from tax.
    In any case, annuity income that you receive in the subsequent years will be subject to income tax.
  3. Lump sum withdrawal
    After Subscriber attain the age of 60, up to 40% of the total corpus withdrawn in lump sum is exempt from tax.

Withdrawal for Tier 2 Account

There is no direct provision for taxation of withdrawal of the Tier 2 account of NPS in the IT Act. 1961.

Also Read NPS Tier 2 Withdrawal | Rules | Taxation | Procedure | Time | 2021

Should I Invest in NPS to Save Tax?

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With the new changes, NPS is evolving to become a part of Exempt-Exempt-Exempt category of investments, similar to the likes of Public Provident Funds, life insurance, and Equity-Linked Saving Schemes.

Today NPS is one of the best retirement plans to opt for to reduce income tax. Tax deductions with NPS can be claimed on investments up to ₹2 lakhs and also returns on NPS investments are exempt from tax-exempt as returns depend on market performance.

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