How Are Retirement Benefits Taxed?

Have you started planning for your retirement yet? Unless you are a Central or State Government employee, we all need to plan our finances for a comfortable retired life. If you are young and believe that you still have quite a few years to start thinking about a retirement plan, you cannot be far from the truth. The younger you start, the better it is for you to build a greater corpus, and that too at a comparatively lower premium eligibility. However, it isn’t enough to simply invest in a pension plan that you feel is the best suited for your unique needs. You also have to know the tax exemptions applicable on each of these pension plans before you take a conscious decision.

Here are the provisions for tax exemptions on retirement plans at a glance.

Section 10(10) - Gratuity for pension plan

• Death cum retirement gratuity received by an individual who is employed by the Central Government, State Government, Defence or local authority is exempt from taxation.
• Any gratuity received by individuals who are covered by the Payment of Gratuity Act, 1972, are exempt subject to following terms and conditions:
  • Gratuity is exempted to the extent of the individual’s last drawn salary for 15 days, applicable for every completed year of service.
  • As per the above calculation, the total annual exemption cannot exceed Rs. 20 lakh. This amount has been increased from the earlier maximum limit of Rs. 10 lakh, as per the provisions notified on 29th March, 2018.
• For employees who are not employed by the Central Government, State Government, Defence or local authority, gratuity received is exempted subject to these terms and conditions:
  • Exemption cannot be more than the salary for half a month, based on the average salary drawn in the last 10 months, for each completed year of service
  • Or, Rs. 10 lakh, whichever is lesser
• In situations where the gratuity was received at least once in a previous financial year, and the individual has availed tax exemptions, the exemption in the current year will be restricted to no more than Rs. 10 lakh.
• The taxable part of gratuity qualifies for tax relief under Section 89(1) of the Income Tax Act, 1961. Gratuity paid to a widow or any other legal heirs in case of the death of an employee while being gainfully employed will be exempted from income tax, as per the provisions dated 21st August, 1990.

Section 10(10A)

Commutation of Pension amount received from a retirement plan

• For employees of Central Government, State Government, Defence, any local authority, or Corporation that is established by Central or State Acts, the entire commuted pension amount is exempted from taxation.
• For individuals employed in any field other than those mentioned above, gratuity amounting to one-third of the pension is exempt from taxes. Or else, the commuted value of half the pension amount is exempted, as per the circulated dated 6th January, 1992. Section 10(10AA) – Leave encashment as a part of pension plan
• Leave encashment, applicable for individuals who are gainfully employed, is fully taxable. As per the provisions mentioned under Section 89(1) of the Income Tax Act, 1961 relief if applicable will be provided.
• Remuneration that is a part of leave encashment for earned leave, payable to employees of Central and State Government at the time of retirement, is fully exempted from taxation.
• For individuals who are not Central or State Government employees, the exemption is restricted to:
  • Cash equivalent to unutilized earned leave, wherein earned leave entitlement cannot be more than 30 days every financial year of actual service.
  • Or, average salary of last 10 months
  • Or, leave encashment actually received, whichever is the least of the three. For employees who have retired after 2nd April 1998, this amount cannot exceed Rs. 3 lakh.
• Leave salary paid to legal heirs of a deceased employee in the form of privilege leave, which had accumulated at the time of the employee’s death is not taxable.

Section 10(10B)

Retrenchment Compensation as a part of retirement plan Retrenchment compensation is the remuneration received by employees under the Industrial Disputes Act, 1947, or any other Act attracts tax exemption subject to the following conditions:

• Compensation amounting to the salary for 15 days, as per the last drawn salary, for every completed year of continuous service or at least for more than 6 months.
• The tax exemption on this compensation cannot exceed Rs. 5 lakh for retrenchment on or after 1st January, 1997, as specified in the circular dated 25th June, 1999.

Section 10(10C)

Voluntary Retirement (VR) compensation towards pension plan

• Payment received by an individual employed by any of the following at the time of termination of service or voluntary retirement is exempted from taxation up to a maximum of Rs. 5 lakh:
  • Central Government or any State Government or the
  • Public sector organization
  • Organizations other than public sector companies
  • Authorities established under State, Central or Provincial Act
  • Local Authorities
  • Cooperative Societies, IITs and other noted educational institutions, Management Institutions, and Universities
• The Voluntary Retirement Scheme under which the compensation is being reimbursed must be formulated as per the provisions of Rule 2BA of the Income Tax Act, 1961. For a company, with the exception of a public sector organization, and a cooperative society, such a VR scheme should be approved by the Chief Commissioner/Director General of the Income Tax Department. However, this provision is applicable only for VR compensations reimbursed before Assessment Year 2001- 2002.
• For exemptions allowed under Rule 2BA for any assessment year, no tax exemption can be allowed in any other assessment year. For tax relief applicable as per Section 89 of the Income Tax Act, 1961, for any assessment year on compensation received after termination of service or voluntary retirement, the individual will not be eligible for any exemption under this clause for any assessment year.

Section 10(11) & Section 10(12)

Payment from Provident Fund (PF) as a part of retirement plan Payments from Provident Fund are tax exempted in the following instances:

• Payment received from a Provident Fund, wherever the Provident Fund Act, 1925 applies
• Payments received from any other PF that is notified by the Central Government
• The Public Provident Fund (PPF) established under the PPF Scheme, 1968
• Accumulated balance payable to an employee from any other Recognised Provident Fund is also exempt to the extent mentioned in Rule 8 of Part A of the Fourth Schedule of the Income Tax Act, 1961.

Section 10(13)

Compensation from Superannuation Fund towards pension plan

Compensation from an Approved Superannuation Fund is liable for tax exemptions, provided the payment as per the provisions specified in Section 10(13), which includes incapacitation, death and retirement.

Conclusion

Pension plans financially safeguard retired employees, securing them from planned and unexpected emergencies. Evidently, the Income Tax Act, 1961, offers a host of provisions for tax exemptions to further benefit retired individuals who have opted for a pension plan. All you need to do is to be aware of these tax exemptions, so that you can make the right choices for your retirement plan.

Recommended Read: Types of Pension Plans in India