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NPS Tier-II investment account: Lucrative option, but lack of clarity on capital gains taxation a dampener

Tax treatment for gains made on investments through NPS Tier-II accounts ought to be similar to that of mutual funds, but remains a grey area in the absence of a formal government notification, say tax experts

March 28, 2023 / 05:42 PM IST
Tax experts are divided over tax treatment of NPS Tier-II capital gains

Tax experts are divided over tax treatment of NPS Tier-II capital gains

Finance Minister Nirmala Sitharaman on March 24 sent shockwaves throughout the mutual fund industry, taking away a key tax arbitrage ― 20 percent long-term capital gains tax with indexation ― that debt funds enjoyed over fixed deposits (FDs).

The new rules will be effective April 1, 2023.

Also read | How the Finance Bill amendments will affect debt mutual fund investors post April 1

Impact on NPS Tier-II investments

Like mutual funds, you can invest in debt (corporate debt and government securities), equity and alternate asset schemes through National Pension System Tier-I (retirement) and Tier-II (investment) accounts. Of these, the latter is a voluntary account that can be opened once Tier-I is activated. NPS Tier-II offers flexible withdrawals, unlike Tier-I.

Since there is no formal notification from the government on how NPS Tier-II gains will be taxed on redemption, tax experts are divided on how the gains are taxed.

Financial planner Suresh Sadagopan, Founder, Ladder7 Financial Advisories, believes that NPS Tier-II can be compared to a savings bank account, as withdrawals are free of restrictions. “The gains made will be taxed at the marginal rate. It will be added to your taxable income and taxed at the slab rate applicable to you,” he explains.

Also read | Worried about NPS’ long lock-in? Try NPS Tier-II

Question mark on tax on Tier-II capital gains

However, lack of government notification on NPS Tier-II taxation leaves scope for ambiguity, say others. “Ideally, this must be taxed as capital gains at the time of withdrawal. However, the exact tax treatment is yet to be notified by the government,” says Abhishek Soni, Co-founder and CEO, Tax2win.

Some tax experts are of the view that the tax treatment for NPS Tier-II gains should be similar to that of mutual funds.

“Since no specific guidance is available with respect to the tax on withdrawals from Tier-II, taking cues from other similar provisions, the gains made on withdrawal, if any, should be taxed as capital gains. The taxability will be similar to that of debt mutual funds,” says Yeeshu Sehgal, Head, Tax Market, AKM Global, a tax and consulting firm.

Now, long-term gains made on equities or equity mutual funds held for more than one year attract a 10 percent tax if they exceed Rs 1 lakh in a financial year. Short-term capital gains are taxed at 15 percent. In case of debt funds, the gains are considered long-term after a holding period of three years and invite a 20 percent tax post indexation. Short-term capital gains get added to the income and are taxed at the applicable slab rate.

However, Soni does not share Sehgal’s opinion on the taxation aspect. “Tax treatment for NPS Tier II gains may not necessarily be similar to that of equity and debt mutual funds. While equity and debt mutual funds are regulated by the Securities and Exchange Board of India (SEBI), NPS is regulated by the Pension Fund Regulatory and Development Authority (PFRDA) and has its own set of rules for investment and operations. There are no specific provisions for taxing withdrawals from Tier II accounts under the law,” he says.

Also read | Tax benefits that come with investing in the NPS

NPS in focus during tax-saving season

NPS is in focus at present not only in the context of the March 24 amendments that affect debt mutual funds, but also the multiple tax benefits that it offers. It figures among the Section 80C instruments that attract maximum attention during the tax-saving season.

While most diligent tax-payers would have already completed the exercise by now, some late-planners are still poring over their existing investments and expenses to figure out the right instrument.

NPS’ multi-layered tax benefits

Making investments meant for the long term ― like NPS ― should not be done at the last minute. But that is what many end up doing towards the end of March. And NPS becomes the automatic choice due to the benefits that it offers beyond the Section 80C limit of Rs 1.5 lakh.

For one, NPS contribution up to Rs 1.5 lakh is eligible for deduction under this section. In addition, you can also claim a tax break of up to Rs 50,000 under Section 80CCD (1B) of the Income Tax Act, 1961. If your employer contributes to your NPS account to the extent of 10 percent (14 percent in case of government employees) of your basic pay and dearness allowance, this amount will qualify for deduction under Section 80CCD (2).

And there’s more. If you are a government employee, you can make investments through NPS Tier-II account ― the investment account that can be opened voluntarily after activating a Tier-I retirement account ― that will be entitled to tax deduction under Section 80C. These investments will, however, be subject to a lock-in period of three years, which is not the case with regular Tier-II investments.

The capital gains conundrum

In case of the Tier-I retirement account, the tax rules on withdrawal are clear. You can make a tax-free lump-sum withdrawal of up to 60 percent of the corpus at vesting (once you turn 60), with the balance 40 percent being converted into equities. You are allowed to make partial withdrawals in the interim to meet important goals, such as house purchase, treatment of critical illness or children’s education.

Like Tier-I, Tier-II, too, allows you to choose a pension fund manager and invest through its schemes ― E (equity), C (corporate debt), G (government securities) and A (alternate assets).

Unless you are a government employee who has chosen this account as a tax-saver avenue, you are free to make withdrawals as and when you feel necessary. Taxation of Tier-II withdrawals, however, remains a grey area.

Given the prevalent ambiguity, tax-payers need to take a calculated call on investing in Tier-II accounts. It is best to ensure that tax-planning is part of your overall financial planning strategy ― do not invest solely with the tax-saving objective in mind, but take into account the value that it can add to your long-term goals.

Preeti Kulkarni
Preeti Kulkarni is a financial journalist with over 13 years of experience. Based in Mumbai, she covers the personal finance beat for Moneycontrol. She focusses primarily on insurance, banking, taxation and financial planning
first published: Mar 28, 2023 05:42 pm