Converging Tax Benefits In NPS And EPF Means Employees Can Now Be Given Choice

You know a big election year is ahead when a government tries hard to propitiate its own employees with additional benefits. A few days ago, the National Democratic Alliance (NDA) government announced that it will raise contributions to the National Pension Scheme (NPS), which covers all central government employees who joined service from 2004, to 14 per cent of basic salary from the current 10 per cent. It will cost the government Rs 2,840 crore and benefit three million employees.

But some of the other benefits announced will also accrue to NPS subscribers outside the government system. These benefits include complete tax exemption on 60 per cent of the corpus withdrawn on retirement (40 per cent remains blocked for the purchase of annuities and the payment of pension, which is taxable), and tax deduction under section 80C for Tier 2 NPS subscriptions. Tier 2 is the withdrawable part of the contribution while Tier 1 cannot be withdrawn till you retire or turn 60.

These changes mean that the two superannuation funds – the employees provident fund (EPF) and the NPS – are converging in terms of tax treatment. The time is thus ripe for giving all employees and employers the option of opting for either. Those already embedded in the EPF system should be able to port their corpuses into the NPS, if they so desire. New employees need not be forced into the EPF against their will.

The changes make NPS less of a pension plan and more of a provident fund with a 40 per cent pension component.

This marks a sea change from the government’s claim in the 2016-17 budget that it was in favour of creating a “pensioned society”. In that budget, Finance Minister Arun Jaitley said he wanted to make the tax treatment of pension and provident schemes similar. But his proposal to make the tax treatment of withdrawals under NPS and the EPF similar had to be abandoned for the latter when workers protested.

Unlike EPF, which is a defined benefit scheme, NPS is a defined contribution scheme, which means that the returns are not guaranteed. EPF returns are fixed every year, and pensions are additionally paid after retirement at certain minimal rates.

This is what Jaitley said in his budget speech in 2016: “Pension schemes offer financial protection to senior citizens. I believe that the tax treatment should be uniform for defined benefit and defined contribution pension plans. I propose to make withdrawal up to 40 percent of the corpus at the time of retirement tax exempt in the case of National Pension Scheme. In case of superannuation funds and recognised provident funds, including EPF, the same norm of 40 percent of corpus to be tax-free will apply in respect of corpus created out of contributions made after 1 April 2016.”

The second half of his statement, to make EPF withdrawals subject to taxation of 60 per cent of the amount withdrawn, had to be scrapped. So, the EPF scheme continues to be exempt from tax at all stages – exempt at the time of contribution, exempt when incomes accrue, and exempt when the corpus is withdrawn (EEE, as it is called) on retirement. NPS is more like EEE plus a small ‘t’ – exempt in the first two stages, and partially exempt when 60 per cent of the corpus is withdrawn. The remaining 40 per cent which goes to the purchase of annuities is taxed when pensions are paid out after superannuation.

The changes in NPS rules take the scheme closer to the EPF, though the 40 per cent compulsory retention for payout of pensions remains in the case of the NPS. It is worth noting that the small pensions paid out to retired EPF subscribers (called the family pension scheme, which is subsidised by the state) are also taxable. But the pension payments here are usually small, and not comparable to the larger payments made under NPS.

This means, by and large, both EPF and NPS are now reasonably comparable, even though one is a defined benefit scheme, with fixed annual returns, and the other is a defined contribution scheme, with no guaranteed returns. The returns vary according to bond and equity market performance. But if one expects NPS to outperform EPF over the longer term given its higher (voluntary) equity contribution component, the overall benefits of EPF’s EEE may not be significantly better than NPS’s EEEt.

As long as EPF was widely seen as better and more stable than the NPS, giving employees a choice made little practical sense. Now, that is no longer the case. Both employers and employees need to be given the option of choosing either. And those already covered by the EPF should have the option of shifting their corpus to the NPS. The EPF, which is the most inefficiently managed superannuation fund in India, must compete with the NPS for future growth.