The government, which succeeded last week in moving a step ahead on pension sector reforms, is now set to review the taxation structure for pension schemes to help subscribers build a decent nest egg.

Individuals investing in the New Pension Scheme and a few other plans can now claim a tax deduction of up to Rs 1 lakh. They will, however, have to pay tax at normal rates when the scheme matures or when they opt out of it. The regulator for this sector the Pension Fund Regulatory and Development Authority has made out a case to the government for extending most favourable tax treatment to the New Pension Scheme saying it would help promote long-term savings. The aim is to make the scheme attractive for all employees by providing a taxation regime that will not pinch those staying invested for a couple of decades.

The New Pension Scheme, which kicked in on January 1, 2004, is based on a defined contribution. Here, a government employee contributes up to 10% of his salary and dearness allowance and a matching contribution is made by the government. This is in contrast to the other pay-as-you-go scheme, in which the benefits to retirees is paid out of the contribution by the existing workforce. This system has put a strain on government balance sheets across the world.

Those who joined government service from January 1, 2004, are already contributing to the New Pension Scheme. So far, it has fetched them an annual return of 8%. They may now be in a position to secure higher returns, as the government has decided to allow the corpus built up so far to be invested in equities and bonds, subject to ceilings.

The scheme envisages employees investing 40% of the proceeds at the time of their exit from the pension scheme. This could either be when the subscriber turns 60 or when there is a premature exit from the scheme. At the time of exit, tax will have to be paid at normal rates on the balance 60% of the amount, which comes as a lumpsum payment to the subscriber.

In the New Pension Scheme, however, employees contributions and accumulations will be tax-free. This method of tax treatment is known as known as exempt-exempt-taxation (EET). The government could look at ushering in an exempt-exempt-exempt (EEE) method, where tax exemption is available at all three stages contribution, accumulation and maturity. In case the government wants to retain EET method for pension, it could look at levying a concessional tax at the time of withdrawal. Any change would mean amendments to the income-tax legislation.

Other instruments that qualify for tax deduction up to Rs 1 lakh include contributions to specified savings schemes, PPF, LIC premium, NSC (series VIII) and unit-linked insurance plans. Just like NPS, individuals investing in specified pension schemes have to pay tax when they receive the pension after retirement.