Taxability of Retirement Benefits in India

Retirement benefits are a critical component of financial planning for employees in India. The Income Tax Act, 1961, governs the tax treatment of various retirement benefits provided by employers. This document outlines the tax implications of common retirement benefits, incorporating recent amendments and clarifications.

1. Gratuity

Gratuity is a lump-sum payment made by an employer to an employee as a token of appreciation for services rendered upon retirement, resignation, or superannuation. The eligibility typically requires completion of a minimum service period (usually 5 years, with exceptions).

• Taxability:

  • Gratuity Received During Service: Fully taxable as salary.

  • Gratuity Received at the Time of Retirement/Termination:

    • Government Employees (including employees of Statutory Corporations): Fully Exempt.

    • Employees Covered Under the Gratuity Act, 1972 (Non-Government): The least of the following is exempt:

      • (15/26) * Last Drawn Salary * Completed Years of Service (or part thereof exceeding 6 months).

      • ₹20,00,000 (Rupees Twenty Lakhs).

      • Actual Gratuity Received.

      • For employees of a seasonal establishment: (7/26) * Last Drawn Salary * Completed Years of Service (or part thereof exceeding 6 months).

      • Salary Calculation: Last Drawn Salary for gratuity calculation means last salary drawn, including basic salary, dearness allowance (DA) if it forms part of retirement benefits, and turnover-based commission excluding bonus, commission, HRA, overtime, and any other allowance, benefits or perquisite

    • Employees Not Covered Under the Gratuity Act, 1972 (Non-Government): The least of the following is exempt:

      • (1/2) * Average Salary * Completed Years of Service.

      • ₹20,00,000 (Rupees Twenty Lakhs).

      • Actual Gratuity Received.

      • Average Salary Calculation: Average salary is the average of the salary drawn in the 10 months immediately preceding the month of retirement.

      • Salary Calculation: Salary means Basic Pay + Dearness Allowance (DA, to the extent it forms part of retirement benefits) + turnover-based commission.

2. Pension

Pension is a regular payment made to an employee after retirement or to their family members after the employee's death.

• Types of Pension:

  • (a) Uncommuted Pension: Paid periodically (e.g., monthly)

  • (b) Commuted Pension: A portion of the pension is converted into a lump sum payment.

• Taxability:

  • Uncommuted Pension: Fully taxable as salary. Exception: Disability pension paid to disabled armed forces personnel is exempt.

  • Family Pension: 33.33% of the family pension, subject to a maximum of ₹15,000, is exempt from tax. Exception: Family pension received by the family members of the armed forces is fully exempt.

  • Commuted Pension:

    • Employees of Central/State Government, Local Authorities, and Statutory Corporations: Fully Exempt.

    • Other Employees (with gratuity received): 1/3 of the commuted pension is exempt.

    • Other Employees (without gratuity received): 1/2 of the commuted pension is exempt.

3. Leave Encashment

Leave encashment refers to the payment received by an employee for unutilized accumulated leave, either during employment or upon retirement/termination.

• Taxability:

  • Leave Encashment During Service: Fully taxable as salary.

  • Leave Encashment on Death of the Employee: Fully exempt.

  • Leave Encashment on Retirement/Termination:

    • Government Employees: Fully Exempt.

    • Other Employees (Non-Government): The least of the following is exempt:

      • Amount actually received.

      • Unutilized Earned Leave * Average Monthly Salary.

      • 10 months' Average Salary.

      • ₹25,00,000 (Rupees Twenty-Five Lakhs).

      • While computing unutilized earned leave, earned leave entitlements cannot exceed 30 days for each year of service rendered to the current employer.

      • Average Salary Calculation: Average of the salary of the last 10 months immediately preceding the retirement.

      • Salary Calculation: Salary = Basic Pay + Dearness Allowance (DA, to the extent it forms part of retirement benefits) + turnover-based commission.

4. Voluntary Retirement Scheme (VRS)

VRS offers employees an option to retire early. Compensation received under VRS is taxable but subject to certain exemptions.

• Taxability: Taxable as "Profits in lieu of Salary."

• Exemption (under Section 10(10C)): The lower of the following is exempt:

  • Compensation received.

  • ₹5,00,000 (Rupees Five Lakhs).

  • Conditions for Exemption:

    • Paid by a specified category of employer.

    • Scheme leads to an overall reduction in the employee strength.

    • Employee has completed 10 years of service or is aged 40 years or more. (Not applicable to employees of a Public Sector Company.)

    • Vacancy is not refilled. Retiring employee cannot be employed by the same management.

    • No prior tax exemption claimed for VRS compensation.

    • Compensation does not exceed:

      • 3 months' salary for each completed year of service or

      • Salary for the remaining period of service.

      • Salary for VRS: Basic Salary + Dearness Allowance (if part of retirement benefits) + Commission.

    • Scheme should apply to all employees (excluding directors).

    • Employee does not claim relief under Section 89.

5. Retrenchment Compensation

Compensation received by a workman upon termination of employment as per the Industrial Disputes Act, 1947, or other relevant laws.

• Taxability:

  • Compensation Under a Scheme Approved by the Central Government: Fully Exempt.

  • Compensation on Closure of the Undertaking Due to Losses: The lower of the following is exempt:

    • ₹5,00,000 (Rupees Five Lakhs).

    • Retrenchment compensation actually received.

    • Average Wage * 15/26 * Completed Years of Service (or part thereof exceeding 6 months).

  • Compensation on Closure of the Undertaking for Reasons Beyond Employer's Control: The lower of the following is exempt:

    • ₹5,00,000 (Rupees Five Lakhs).

    • Retrenchment compensation actually received.

    • Average Wage * 3 months.

6. Provident Fund (PF)

A retirement savings scheme where contributions are made by both the employee and employer.

• Types of Provident Funds and Tax Treatment:

  Feature	Recognised Provident Fund (RPF)	Statutory Provident Fund (SPF)	Unrecognised Provident Fund (UPF)
  Employer's Contribution	Exempt up to 12% of salary (Basic + DA). Taxable above 12% or if the aggregate employer contribution to RPF, NPS, and Superannuation Fund exceeds ₹7,50,000.	Not Taxable	Not Taxable
  Employee's Contribution	Eligible for deduction under Section 80C.	Eligible for deduction under Section 80C.	Not eligible for deduction under Section 80C.
  Interest Earned	Exempt. Taxable if the interest exceeds the notified rate or interest related to employee's contribution exceeds ₹5 lakh in case no employer contribution, or, interest related to employee's contribution exceeds ₹2.5 lakh, in case employer has also contributed.	Exempt, however, Taxable if the interest relating to the employee's contribution above Rs. 5 lakh, in case no contribution is made by the employer, or interest relating to the employee's contribution above Rs. 2.5 lakh, in case employer has also contributed to the fund	Not taxable at the time of accrual.
  Withdrawal (After 5 Years)	Exempt.	Exempt.	Taxable: (a) Employer's contribution; (b) Interest on employer's contribution; and (c) Interest on employee's contribution
  Withdrawal (Before 5 Years)	Taxable: (a) Employer's contribution; (b) Interest on employer's contribution; and (c) Interest on employee's contribution	Exempt	Aggregate of the followings shall be taxable: (a) Employer's contribution; (b) Interest on employer's contribution; and (c) Interest on employee's contribution

  • Salary = Basic Pay + Dearness Allowance (if forming part of retirement benefits)

7. National Pension System (NPS)

A retirement savings scheme regulated by the Pension Fund Regulatory and Development Authority (PFRDA).

• Tax Treatment:

  • Contributions:

    • (a) Employee's Contribution: Deductible under Section 80C up to 10% of salary, plus an additional deduction of ₹50,000 under Section 80CCD(1B).

    • (b) Employer's Contribution: Deductible up to:

      • 14% of salary for Central/State Government employees.

      • 10% of salary for other employees.

    • (c) Self-Employed Individuals: Deductible up to 20% of gross total income, plus an additional deduction of ₹50,000 under Section 80CCD(1B).

  • Accumulation: Yearly returns on the corpus are tax-free.

  • Withdrawal:

    • (a) Partial Withdrawal: Exempt to the extent of 25% of the contributions made by the employee.

    • (b) Final Withdrawal at Retirement/Opting Out: Exempt up to 60% of the total corpus. The remaining 40% is mandatorily used to purchase an annuity, which is taxable as pension.

    • (c) Amount Received by Nominee on Death of Subscriber: Fully exempt.

  • Pension Income (from NPS annuity): Fully taxable.