How gains from NPS Tier-II investments may be taxed

Government employees investing in NPS Tier-II accounts can claim deductions under section 80C, but this will come with a lock-in period of three years, like ELSS

Besides Section 80C instruments offered to all taxpayers, central government employees have an additional tax-saving investment option: a National Pension System (NPS) Tier-II (investment) account.

In September 2020, the central government introduced an NPS Tier-II variant (NPS–TTS) with a three-year lock-in period, which is open only to central government employees who have an active NPS Tier-I (primary, retirement) account. They can invest in this scheme and avail of tax deductions of up to Rs 1.5 lakh under Section 80C.

While the scheme has not found great favour with this section of taxpayers, it is an option they can consider ahead of the March 31 deadline for making tax-saving investments for FY24.

Also read: How your employer's contribution to your NPS can reduce your tax outgo

NPS Tier-II account offers withdrawal flexibilities

Besides central government employees, all citizens of India can voluntarily open this account to benefit from the low-charge structure that NPS offers only if they also maintain an NPS Tier-I account.

Like mutual funds, investments can be made in debt (corporate debt and government securities), equity and alternative asset schemes through Tier-I as well as Tier-II accounts. NPS Tier-II offers flexible withdrawals, unlike Tier-I, where the money is locked in until the date of vesting - when the account holder turns 60.

In the case of Tier-I, up to 60 percent of the funds can be withdrawn without tax implications, and the balance has to be mandatorily converted into annuities, which will ensure a regular, lifetime pension income.

Partial withdrawals are also allowed in the interim to meet important goals such as house purchase, treatment of critical illness or children’s education.

How are Tier-II gains taxed?

In the case of Tier-I retirement accounts, the tax rules on withdrawal are clear. Tier-II also allows you to choose a pension fund manager and invest through its schemes ― E (equity), C (corporate debt), G (government securities) and A (alternative assets).

However, unless you are a government employee who has chosen this account as a tax-saver avenue with a three-year lock-in, you are free to make withdrawals as and when you feel necessary.

So far, though, there is no clarity on how gains made on the sale of NPS Tier-II units will be taxed on redemption. Some experts are of the opinion that given its withdrawal flexibilities, any gains made should be included under the 'Income from Other Sources' head, added to taxable income and taxed at the applicable slab rate.

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

Taxed like bank deposit interest or mutual fund capital gains?

However, the other, opposing view is that the absence of a government notification on NPS Tier-II tax treatment leaves scope for ambiguity.  Such experts say the tax treatment for NPS Tier-II gains should be similar to that of mutual funds.

"Ideally, the income tax department and the Pension Fund Regulatory and Development Authority (PFRDA) should come out with clear guidelines on the tax treatment of NPS Tier-II gains. So, for now, a lot depends on your interpretation," said Chetan Chandak, director of TaxBirbal, a tax consultancy firm.

He said that since NPS investment would be a capital asset, the gains made on withdrawal (redemption) should be treated as capital gains. "I am aligned with the view that the treatment will be at par with that of mutual funds," he said.

"There is no fixed rate of return, so gains on withdrawal from Tier-II should not be categorised as 'income from other sources' but capital gains," said Mayank Mohanka, founder-director of TaxAaraam India, a tax consultancy 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.

"However, NPS Tier-II gains cannot be treated at par with capital gains on equity assets as these are exempt from Securities Transaction Tax (STT)," Mohanka said.

This would mean that NPS Tier-II investments would attract the tax treatment of debt mutual funds. In the case of debt fund units purchased after April 1, 2023, the gains - even when units are held for over three years - no longer enjoy long-term capital gains tax (LTCG) rate of 20 percent or indexation benefits. Such gains are simply added to your taxable income and taxed at the marginal rate applicable to you.

"However, there is no notification from the government which extends these changes to NPS funds. So, gains made on redemption after a three-year holding period will be treated as long-term capital gains (20 percent tax with indexation) and if the holding period is shorter, then the gains will be taxed at the slab rate," said Mohanka.

Chandak, however, said that debt mutual fund taxation rules apply to Tier-II funds too, with the date of acquisition being crucial. If you made these investments prior to April 1, 2023, then your NPS Tier-II long-term capital gains (held for more than three years) at redemption will attract a tax of 20 percent with indexation.

If the holding period is shorter, then the gains will be added to your taxable income and taxed as per the slab rate applicable to you. If you have invested after April 1, 2023, gains on redemption will be added to your taxable income and taxed at the marginal rate.

"The general rule is that if there is ambiguity in tax rules, the interpretation beneficial to the taxpayer will prevail," he added. In this case, for those who invested after April 1, 2023, the implications of taking either path (capital gains or interest income treatment) will yield the same result - the gains will be added to your taxable income to be taxed as per the slab rate.

"Those who invested prior to April 1, 2023, however, will have to go with one particular interpretation (LTCG or income from other sources)," said Chandak.

If you are a central government employee looking to invest in NPS Tier-II with tax saving on your mind, bear these tax tangles in mind before you take a call.