There has been a lot of confusion regarding the exit and withdrawals rules of the National Pension System (NPS). I apologise if I have contributed to it. In this post, I shall attempt to get rid of my own confusion and clarify my understanding.
Until today I have incorrectly believed that 40% of the NPS corpus can be withdrawn tax-free, either upon retirement or before and thought that the NPS regulator PFRDA would announce a revision to its PFRDA (Exits and Withdrawals under NPS) Regulations.
Budget 2016 did not change the exit and withdrawal rules. It only added a clause with regard to how much would of the amount withdrawn be subject to tax.
Here is an extract from the budget memorandum (written in normal English!)
It is proposed to provide that any payment from National Pension System Trust to an employee on account of closure or his opting out of the pension scheme referred to in Section 80CCD, to the extent it does not exceed forty percent of the total amount payable to him at the time of closure or his opting out of the scheme, shall be exempt from tax. However, the whole amount received
by the nominee, on death of the assessee shall be exempt from tax.
This proposal is now part of the finance act 2016 (page 8).
Current NPS Withdrawal and Exit Rules
A normal exit from NPS is at the age of retirement. This could be 58, 60 or 65 - as defined by our organisation.
If ₹ 10 Lakh is the corpus at the time of retirement:
40% or ₹ 4 lakh has to be annuitized. That is we need to buy an annuity policy from one of the annuity providers designated by NPS. We will get a pension which is fully taxable as per slab. To understand what an annuity is, and the different choices available, see How Annuity Plans Work
Now ₹ 6 Lakh is the cash in hand. According to the finance act 2016,
forty percent of the total amount payable to him at the time of closure or his opting out of the scheme, shall be exempt from tax
There was some confusion regarding this, but thanks to Manoj Nagpal who clarified this to mean: 40% of the total corpus at the time of withdrawal = ₹ 4 lakh in the current example.
Therefore out of ₹ 10 Lakh,
₹ 4 Lakh --> is to be annuitized (this purchase can be delayed up to three years to get a better interest rate)
₹ 4 lakh out of the remaining ₹ 6 Lakh is tax-free. This is the key point. In the case of normal retirement, this does not matter, though.
The remaining ₹ 2 Lakh will be taxed as per slab at the time of withdrawal.
The balance amount of ₹ 6 lakh can be deferred up to age 70 by giving in writing 15 days before retirement(!) This gives one the idea of deferring tax in the assumption that tax slab will lower with age. Too many ifs and buts here and it is folly to assume that. Excuse me, but I would like to retire rich.
I will not be making plans of deferring pension or tax years or decades away and assume 'NPS will be a good instrument when I withdraw'.
Premature exit from NPS
Exit before the designated age of retirement is premature (or early exit). It is in this case, the application of the rules has to be done carefully.
Let us again suppose that I have ₹ 10 Lakh and wish to exit at the age of 50.
Now we need to re-read the act:
.. any payment from National Pension System Trust to an employee on account of closure or his opting out of the pension scheme referred to in Section 80CCD, to the extent it does not exceed forty percent of the total amount payable to him at the time of closure or his opting out of the scheme, shall be exempt from tax ..
Any payment from the NPS trust is subject to the above regulation. The act does not say define the amount to be paid by the trust. Huge difference!
To reiterate: If I exit early from NPS, "the 40% of corpus= tax-free" rule does not apply in the way we want it to!!
According to NPS exit and withdrawal rules, a subscriber has to buy a pension plan (annuity) for 80% of the corpus. That is, ₹ 8 lakh will be locked away in an annuity. I have said it before, and I will say it again: Stay away from Corporate NPS, if You Wish to Retire/quit your job ASAP!
It is stupid to assume that we will continue to work until the normal age of retirement. Those fairy tales occur on Excel sheets, not in real life. Liquidity is the most important aspect of an investment. Therefore do not invest Rs. 50,000 in NPS for saving tax!
Now, ₹ 2 lakh will be the cash in hand. The finance act 2016 is applied in the following way: ₹ 2 lakh is less than ₹ 4 lakh (40% of total corpus = max tax-free limit).
Therefore, ₹ 2 lakh is tax-free.
Notice how this works: 40% of the total corpus at the time of exit = tax-free.
Upon normal exit(retirement): the maximum amount that can be withdrawn = 60% of the corpus. Out of this (and only out of this), 40% of the total corpus is tax-free.
So, 60% of total corpus - 40% of total corpus = 20% of total corpus is taxable as per slab (If max withdrawal is made)
I got this part right, but by chance!
Upon early exit: the maximum amount that can be withdrawn = 20% of the corpus. This is always less than 40% of the total corpus and therefore will be tax-free.
I thought this part required more clarity. It was available, I just failed to see it. Apologies.
All of the above is with respect to tier 1. Although the NPS is a mutual fund, tier 1 is not a capital asset. So capital gains taxation rules do not apply.
Tier 2 is not part of the pension system and it is not clear whether it will be taxed as per slab or as a mutual fund.
NPS Trivia: Only forty percent of the tax that you save using NPS is truly tax-free (if you retire normally). I can cast this sentence in a positive and misleading way: Forty percent of the gains made from NPS is tax-free upon normal retirement 🙂
Another example of how illiquid this is: NPS: Partial Withdrawal Rules 2016.
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