Taxation of Retirement Benefits

Introduction

When an employee retires from his employment after completion of service, it’s called as retirement on superannuation. on retirement, he/she receives certain benefits like gratuity, leave encashment, pension etc. These benefits are profits in lieu of salary and are taxable as ‘income from salary’. These benefits are partly exempt or fully exempt and the taxable or exempt portion of such benefits is computed as discussed in section 10 of the Income tax Act.

Gratuity

Gratuity is given by the employer to his/her employee for the services rendered by him during the period of employment. The computation of gratuity, eligibility conditions and legal issues are governed by Payment of Gratuity Act, 1972.

The salient features of Gratuity

  • Every employer having 10 or more employees is required to pay gratuity to his employees. However, in future even of the number of employees goes below 10, then also the responsibility to pay the gratuity stays
  • The gratuity is payable after termination of service through resignation, retirement on superannuation or death or disablement due to disease after completion of FIVE years of continuous service
  • The amount of gratuity payable to an employee shall not exceed Rs.20,00,000/- from F Y 2018-19
  • The gratuity is payable to an employee within 30 days of it becoming due (date of termination of service), this date may only be extended if there is a fault on the part of the employee
  • Every employer other than Government, must obtain group gratuity insurance for the payment of gratuity from LIC India

Computation of amount of gratuity

The employee is entitled to get about half a month’s Basic and Dearness Allowance (DA) for every completed year of service as gratuity.

The gratuity is computed as under:

(Number of years of service) x (Last drawn monthly Basic and DA) x15/26.

Therefore, if the employee has served 20 years in the organisation and draws a monthly Basic and DA of Rs. 40,000 then when he leaves the job, he will get gratuity of Rs. 4,61,538/-, calculated as (20 x 40,000 x15/26).

The organisation can choose to pay the employee more, but the maximum amount of gratuity, as per law cannot exceed Rs. 20 lacs. Amounts paid above this will be ex-gratia.

Taxability of gratuity

  • The gratuity received by the Government employees is fully exempt from tax.
  • In case of the employees other than the Government employees, the least of the following amounts shall be exempt from tax:
    1. Actual amount of gratuity received
    2. Amount calculated at 15 days’ wages for each completed year of service or part thereof more than 6 months
    3. Amount of Rs. 20,00,000/-

Pension

The pension is a periodical allowance, or an amount of stipend received by a person because of a past service or a merit of a person. The pension is a compensation for past service. It has its origin in past employer-employee relationship or a master-servant relationship. This amount is paid based on earlier relationship of an agreement of service as opposed to an agreement of current service. Such a relationship is valid till the death of a concerned pensioner.

Commuted pension

  • Pension is received by the employee on retirement from service. Part of such pension can be claimed by employee on a lump sum basis and is called as commuted pension and rest is un-commuted pension.
  • If the employee is eligible for a pension of Rs. 50,000/- he may claim commuted pension of Rs. 10000/- per month for next ten years. Hence, his commuted pension in lump sum is Rs.12,00,000/- and then he will receive Rs. 40,000/- as pension for 10 years and afterwards 50,000/- per month.
  • The taxability of pension depends upon whether it is a commuted pension or un-commuted pension. The un-commuted pension is fully taxable except in cases of Gallantry Award winners and United Nations employees.
  • The family pension received by the widows and children of military personnel where the death of such personnel occurred during circumstances involving operational duties is exempt from tax.
  • The commuted pension in case of Government Employees is fully exempt and not taxable.
  • The commuted pension in case of employees other than Government employees is exempt up to a certain limit as follows:
    1. Where employee has received gratuity, commuted value of one-third of pension is exempt.
    2. In other cases, commuted value of one-half of such pension is exempt.

Illustrated:

A pension of a retired employee is fixed at Rs.60000 per month. He commuted Rs.30000 out of his pension for next ten years and received Rs. 36,00,000/- as commuted pension amount. Then,
In case of (a) commuted value equivalent to one third of pension shall be exempt which works out to (3600000 X 20000/30000) Rs. 24,00,000/- shall be exempt.In case of (b) above, 1200000 X 30000/10000=36,00,000/- shall be exempt from tax.

  • In case the Pension is received by an individual from the LIC Pension Fund or any other Insurer, the entire pension received is exempt from tax.

Family Pension

In the event of death of the pensioner employee, the family of the said pensioner receives the pension from employer or the bank. Such a pension is called as Family Pension. This family pension differs from the pension in one respect in that the pension is paid or received because of an employer-employee relationship, but that relationship does not exist in case of a family pension. The pension is paid during the lifetime of an employee whereas the family pension is paid in the event of his death to his family members. Therefore, this family pension is taxed as Income from Other Sources. In respect of income from family pension, deduction up to Rs.15000/- or 1/3rd of the pension amount received whichever of the two is lesser can be claimed.

The family pension received by a widow or children of armed forces personnel who has died while on duty is exempt from income tax. This is expressly provided in section 10(19) of the Income tax Act.

Provident Fund Contributions and payments

There are different kinds of provident funds, which are utilized by a person for the purposes of investments and regular savings. These funds differ from each other in their operation and taxability. They are also governed by different set of rules.

The Provident Funds are categorized as follows:

  • Statutory Provident Fund/General Provident Fund – This is set up under the Act of the Parliament i.e. Provident Funds Act, 1925. This fund is maintained by Government and Semi-Government organizations. The Government employee contributes a certain amount of salary to this fund. The accumulations in this fund are paid to the Government employee at the time of retirement or superannuation. Every Government employee can have this account but the GPF is not available to the private sector employees. This fund can be used to draw advances known as GPF advances which are interest free and are to be repaid in monthly installments. There is no bar on number of GPF advances. This fund matures at retirement or superannuation.
  • Recognized Provident Fund – This fund is one which is recognized by the Commissioner of Income-tax according to the rules and provisions contained in the Income-tax Act. It includes a provident fund established under a scheme framed under the Employees’ Provident Funds Act, 1952. This fund is maintained by private sector organizations. This is a popular Employees Provident Fund. Any employer with 20 or more employees must register with this EPF and contribute to this Fund.
  • Public Provident Fund – This Fund is an investments and tax saving instrument for Resident Individuals. The PPF account can be opened at any of selected branches and subsidiaries of designated nationalized banks and selected post office branches. The minimum contribution for investment is Rs. 500 and maximum is Rs.1.5 lacs. It is a 15 years scheme and the account mature only after 15 years. There is no room for premature withdrawal with PPF. There is no facility of loans or advance from PPF or against PPF.
  • Unrecognized Provident Fund – Unrecognized provident fund is that provident fund which is neither a statutory provident fund nor a recognized provident fund and which is also not a public provident fund.

The issue of taxability in respect of these funds arises at the time of paying contributions into the fund, receiving the matured amount from the fund and the interest earned on the fund. The taxability at each of the stage is discussed as under:

Type of Provident Fund Statutory provident fund Recognized provident fund Unrecognized provident fund Public Provident Fund
Employer’s contribution to provident fund Exempt from tax Exempt up to 12 per cent of salary; excess of employer’s contribution over 12 per cent of salary is taxable Exempt from tax Not Applicable
(even if employee deposits into your PPF, it will be treated as part of salary)
Deduction under section 80C on employee’s contribution Available Available Not available Deduction is available on contribution made by account holder
Interest credited to provident fund Exempt from tax Exempt from tax if rate of interest does not exceed the notified rate; otherwise, excess of interest over the notified rate is taxable Exempt from tax Fully exempt
Lump sum payment at the time of retirement or termination of service. Exempt from tax Exempt from tax in some cases, otherwise provident fund will be treated as an un-recognized fund from the beginning Payment received in respect of employee’s own contribution is exempt from tax, Interest on employee’s contribution is taxable under the head “Income from other sources” and balance is taxable under the head “Income From Salaries”. However, relief can be claimed under section 89(1) Fully exempt

 

Superannuation Fund Payments

Taxability of receipts from and payments to Approved Superannuation Funds

Kind of receipt income Taxability
Employer’s contribution to Superannuation Fund Fully exempt
Deduction under section 80C on employee’s contribution Available
Interest on accumulated balance Fully exempt
Lump sum payment at the time of retirement or termination of service. Exempt from tax with following conditions:

  • Exemption is available only in respect of the payments received on retirement at or after a specified age.
  • Payments made on resignation will be exempt only if it is after the specified age.
  • Amount transferred from approved superannuation fund to New Pension System account shall be exempt

Leave Encashment

  • When an employee retires on completion of a service with employer, sometimes he is paid cash amount equivalent of the unutilized leave at the time of such retirement.
  • The Government employees are universally paid this amount at the time of retirement if they have leave at their credit. In this case the entire amount of leave encashment is TAX FREE
  • The taxability of such an amount of leave encashment in respect of employees other than Government employees is as under:
  • In respect of other employees least of the following shall be exempt from tax (Applies to leave encashment received from more than one employer)
    • Cash equivalent of leave entitlement to the maximum extent of 30 days for every completed year of actual service rendered for the employer from whose service the employee has retired.
    • 10 months’ average salary. Average salary is to be calculated based on average salary drawn during the period of 10 months immediately preceding the retirement/superannuation
    • Actual amount of leave encashment received at the time of retirement.
    • Rs. 300,000/-

Retrenchment Compensation

  • Retrenchment means the termination of the employment of employee other than dismissal out of punishment or voluntary retirement. This is generally done as a measure to reduce the expenditure by an organization when it is going through financial difficulties.
  • When the employees are subjected to retrenchment, an organization pays them the compensation which is termed as ‘retrenchment compensation’. This compensation is exempt up to certain amount u/s 10(10B) of the Income tax Act as follows:
  • Least of the following amount shall be not taxable:
    1. Amount calculated at 15 days’ average pay for every completed year of continuous service (service more than 06 months will be considered as a year)
    2. Rs.500,000 OR
    3. Actual amount of compensation received

Voluntary Retirement from Service (VRS) compensation

Employees of some of the undertakings of Government are eligible to be covered under the Voluntary Retirement Scheme (VRS). On such VRS, they are eligible to receive a certain amount in lumpsum which is known as VRS compensation.

The employees of following organizations are eligible for VRS

    • Public sector companies.
    • Any other company.
    • Authority established under a Central, State or Provincial Act.
    • A Local authority.
    • A Co-Operative society.
    • Universities.
    • Indian Institutes of Technology.
    • Notified Institutes of Management: 
      1. Indian Institute of Management, Ahmadabad
      2. Indian Institute of Management, Bangalore
      3. Indian Institute of Management, Calcutta
      4. Indian Institute of Management, Lucknow
      5. Indian Institute of Foreign Trade, New Delhi
    • Central Government (from 1-4-2002).
    • State Government (from 1-4-2001)
    • Other notified Institutions are as under:
      1. International Crops Research Institute for the Semi-Arid Tropics
      2. Action for Food Production, New Delhi (AFPRO)
      3. Government Tool Room & Training Centre, Rajajinagar Industrial Estate, Bangalore

The compensation received because of VRS is eligible for exemption from tax upto Rs. 500,000/- or received whichever is lower.

The exemption is available ONLY once and cannot be claimed in more than one A Y.

What are the guidelines laid down for VRS Scheme?

These guidelines are laid down in rule 2BA of the Income tax Rules, which stipulate that the scheme framed by the employer should be in accordance with the following requirements:

  1. It applies to an employee who has completed ten years of service or completed 40 years of age.
  2. It applies to all employees except directors of a company or of a co-operative society.
  3. The scheme of voluntary retirement or separation is intended to result in overall reduction in the existing strength of the employees.
  4. The vacancy caused by voluntary retirement or voluntary separation is neither to be filled up nor the retired or separated employee be absorbed in any other company or concern under the same management.
  5. The amount received or receivable on VRS of the employees does not exceed the amount equivalent to three months’ salary for each completed year of service OR salary at the time of retirement multiplied by the balance months of service left before the date of his retirement on superannuation.
  • What does the salary mean for computation of VRS compensation?The salary in connection with computation of VRS compensation means the Basic Salary and Dearness allowance and turnover commission, if it has formed the basis of computation of income from salary.
    1. A lump sum payment made gratuitously or by way of compensation or otherwise to the widow or other legal heirs of an employee, who dies while still in active service, is not a taxable income. Circular No. 573, dated 21-8-1990.
    2. There can be situations in which a person or his heir receives ex gratia payment from the Central Government/State Government/Local Authority/Public Sector Undertaking, consequent upon injury to the person/death of a family member, while on duty. Such an ex gratia payment will not be liable to income-tax. Circular No. 776, dated 8-6-1999