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How not to let tax hit NPS redemption
August, 31st 2016

The National Pension System (NPS) provides numerous tax benefits to its subscribers. Apart from providing tax benefits of up to Rs 1.5 lakh along with under instruments under Section 80C, NPS has an exclusive window of Rs 50,000 under Section 80CCD (1).

Employers can also contribute upto 10% of the salary (basic + dearness allowance) to your NPS account.Under Section 80CCD (2), this will not be treated as taxable income in your hand, so this is an additional tax-saving window. It has a few other advantages such as low-cost fund management and ability to change asset allocations in the middle without tax incidents.

However, NPS follows the EET regime, which stands for exempt, exempt, tax. What this means for investors is that while you get tax benefit at the time of an investment and also at the time of accumulation (there will not be any tax incidence for the returns earned in the middle), the final withdrawal will be taxable. In other words, you are not saving tax, but only deferring it.

The government has recently sugarcoated NPS in the last budget by making 40% of the final corpus tax-free in your hand. So we can say that NPS is now a mixture between EET (60%) and EEE (40%).

Now let us consider strategies to reduce the tax incidence on the 60% of accumulated corpus. And the first strategy (ie most commonly used now also) is to use this to buy annuities. And as per current PFRDA regulations, you have to compulsorily use 40% of the accumulated corpus to buy annuities, so the decision here is only about the remaining 20%.

Though you save immediate tax on this 20% corpus, the annuity you receive in future will be taxable."Though annuity is taxable, its impact will be lower because the annuity amount will be lower compared to the one time receipt," says Anil Lobo, India Business Leader - Retirement, Mercer.

Second strategy is to delay buying of annuity and also withdrawal of remaining money . This makes sense because it is natural that the tax slab usually comes down post retirement.

For example, if your tax slab falls from 30% to 10% after retirement, you are saving 20% tax on this accumulated corpus. By doing that, investors can also decide the specific financial year (one with very low other income) in which they want to receive this corpus. Since insurance companies pay higher annuity rates for people with higher age, you should delay it as much as possible.

However, there is some restriction on how much you can delay the annuity-buying part.

"Though subscribers can delay lump sum withdrawal till 70, they have to buy annuity before 63 as per current PFRDA rules," says Sumit Shukla, CEO, HDFC Pension Funds. "Hope PFRDA will allow annuity buying also till 70."

Third strategy is to split the withdrawal to different years (instead of lump sum). "You can reduce the tax liability on 20% taxable corpus by splitting them into 10 equal instalments of 2% each," says Lobo. Since each of these instalments (2% each) will be small, the tax hit from that will also be low. "You can also smartly use the 25% early withdrawal facility for this," points out Manoj Nagpal, CEO, Outlook Asia Capital.

As per amended rules, NPS investors are allowed to with investors are allowed to withdraw upto 25% of their contributions (not that by companies) for defined needs like children's higher education or marriage, construction or purchase of first house, treatment of critical illness for self, spouse, children or parents.

Assume that your NPS account is a personal one and you have withdrawn 25% for this purpose.

"While withdrawing 25% from NPS, subscriber is neither closing his NPS account nor is he opting out of scheme. Therefore, there will be no taxation at the time of partial 25% withdrawal, as the taxation rule under Section 80CCD (3) is applicable only at the time of exit," says Suresh Surana, founder, RSM Astute Consulting Group.

Since 40% of the final corpus (75% now after the partial withdrawal of 25%) is also tax free, the next 30% will also be tax free.

This means that the total tax exempted withdrawal goes up to 55% (25% + 30%) from 40%. Similarly , the hit because of compulsory annuity will also come down because that restriction is based on this reduced final corpus. "40% annuity buying restriction is based on the corpus at the time of retirement," says Shukla.

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