When planning for retirement, most individuals focus on building a substantial corpus to ensure financial stability in their golden years. However, the process of retirement planning can also offer significant tax-saving opportunities. One such powerful savings option is the National Pension System (NPS). Not only does it help in creating a retirement fund, but it also allows individuals to reduce their tax liability in a big way.
In this article, we will explore how the NPS tax benefit can effectively reduce one's tax liability while simultaneously ensuring a comfortable retirement.

Understanding the National Pension System

The National Pension System is a government-backed pension program aimed at providing long-term financial security for Indian citizens. Launched in 2004 and regulated by the Pension Fund Regulatory and Development Authority (PFRDA), NPS is open to both salaried and self-employed individuals.
Participants contribute to their NPS accounts during their working years, and the accumulated corpus is used to provide income post-retirement. The system also offers considerable flexibility, allowing investors to select the asset mix of equity, government securities, and corporate bonds based on risk tolerance.
Apart from the retirement benefits, one of the most compelling aspects of NPS is the tax savings it offers. Let’s examine how NPS tax benefits can help reduce your tax burden.

NPS Tax Benefit Under Section 80C

One of the primary sections of the Income Tax Act that allows taxpayers to save on taxes through NPS is Section 80C. This section offers a wide range of tax-saving investment options, and NPS is one of the most effective among them.
Here’s how Section 80C works in the context of NPS:
1. Tax Deduction of Up to Rs. 1.5 Lakh: Contributions made towards NPS are eligible for a deduction of up to Rs. 1.5 lakh in a financial year under Section 80C. This helps in reducing your taxable income and saving a significant amount on taxes.
2. Combining NPS with Other 80C Investments: If you have already utilised the Rs. 1.5 lakh limit under Section 80C by investing in other instruments like Public Provident Fund (PPF), life insurance premiums, or Employee Provident Fund (EPF), you can still save more on taxes through NPS, as we’ll discuss further.
3. Employee’s Contribution to NPS: For salaried individuals, the contributions they make towards their NPS accounts are eligible for tax deductions under this section. This allows salaried taxpayers to optimise their tax savings while ensuring financial security for retirement.

NPS Tax Benefit Under Section 80CCD(1B)

In addition to the benefits under Section 80C, NPS offers an exclusive tax benefit under Section 80CCD(1B). This section was introduced specifically to encourage higher participation in NPS by providing an additional tax-saving opportunity over and above the Rs. 1.5 lakh deduction under Section 80C.
Here’s how you can leverage Section 80CCD(1B):
1. Additional Deduction of Rs. 50,000: Contributions made towards NPS are eligible for an extra deduction of up to Rs. 50,000 under Section 80CCD(1B). This deduction is over and above the Rs. The 1.5 lakh limit of Section 80C allows taxpayers to claim a total deduction of Rs. 2 lakh annually.

2. Benefits for Both Salaried and Self-Employed: Whether you are salaried or self-employed, you can claim this additional deduction by contributing to your NPS account. This makes NPS an excellent tax-saving instrument for all types of taxpayers.

3. Optimised Tax Savings: By combining the Rs. 1.5 lakh deduction under Section 80C with the Rs. 50,000 deduction under Section 80CCD(1B), taxpayers can reduce their taxable income by up to Rs. 2 lakh. This translates into significant tax savings, especially for those in higher tax brackets.

NPS Tax Benefit Under Section 80CCD(2) – Employer Contributions

Section 80CCD(2) introduces another tax-saving element of NPS, particularly for salaried employees. Under this section, the contributions made by an employer to an employee’s NPS account are eligible for tax deductions.
Here’s how Section 80CCD(2) benefits both employers and employees:
1. Employer’s Contribution: Employers can contribute up to 10% of the employee’s basic salary (including dearness allowance) towards the NPS. This contribution is deductible under Section 80CCD(2), making it a great tax-saving tool for employers. This is up to 14% of the basic salary and dearness allowance for government employees.

2. Tax-Exempt for Employees: The contributions made by the employer towards NPS are not included in the taxable income of the employee. This allows employees to enjoy higher contributions without an increase in their tax liability.

3. No Cap on Deduction: Unlike Sections 80C and 80CCD(1B), where there are specific limits to the amount of deduction, there is no upper limit for deductions under Section 80CCD(2). The only constraint is that the employer’s contribution cannot exceed 10% of the employee’s basic salary.

How NPS Helps in Reducing Tax Liability?

Individuals can substantially reduce their tax liability by taking advantage of the various deductions available through NPS. Here’s a summary of how you can use NPS for tax planning:
1. Deduction under Section 80C: Rs. 1.5 lakh for contributions made by the employee.
2. Additional Deduction under Section 80CCD(1B): Rs. 50,000 for additional NPS contributions.
3. Employer’s Contribution under Section 80CCD(2): Tax-deductible contributions by the employer, with no upper monetary limit.
Together, these provisions allow you to save taxes on contributions up to Rs. 2 lakh, and if your employer contributes to your NPS account, the savings can be even more significant.

NPS and Taxation at Maturity

While NPS offers tax deductions during the accumulation phase, it’s also important to understand the tax treatment at maturity. The system follows an Exempt-Exempt-Tax (EET) regime, meaning that while the contributions and earnings during the investment period are tax-exempt, withdrawals are partially taxable.
1. 60% Lump Sum Withdrawal: Upon reaching retirement age (60 years), NPS subscribers can withdraw up to 60% of their total corpus. Of this, 40% is tax-free, while the remaining 20% is added to your taxable income and taxed as per the applicable income tax slab.
2. 40% Annuity Purchase: The remaining 40% of the NPS corpus must be used to purchase an annuity, which will provide regular pension payments post-retirement. The annuity income is taxable in the year it is received, based on your income tax slab.
3. Partial Withdrawals: Subscribers can make partial withdrawals from NPS under certain conditions, such as for medical emergencies or higher education expenses. These partial withdrawals, up to 25% of the subscriber’s contributions, are tax-free.

Long-Term Benefits of Using NPS for Retirement Planning

Beyond the tax benefits, NPS helps in building a robust retirement fund. The contributions you make towards NPS are invested in a mix of equities, government securities, and bonds, offering market-linked returns. Historically, NPS has provided better returns than other traditional savings schemes.
Over the long term, these investments grow into a sizable corpus, ensuring financial security after retirement. The added flexibility of deciding your investment mix and switching between asset classes gives you control over your retirement savings.

Conclusion: Leverage NPS for Tax Savings and Retirement Security

The National Pension System is not only an excellent retirement planning tool but also a powerful way to reduce your tax liability. By using the NPS tax benefit provisions under Sections 80C, 80CCD(1B), and 80CCD(2), you can claim tax deductions of up to Rs. 2 lakh, making it a highly tax-efficient investment.
For salaried individuals, the employer’s contribution under Section 80CCD(2) provides even more scope for tax savings. Moreover, the growth potential of NPS makes it a superior investment for long-term wealth creation.
So, if you haven’t yet explored NPS, now is the time to start. By investing in NPS through leading banks like ICIC Bank, you can secure your retirement while saving on taxes—a win-win for your financial future!