Income Tax applicability on Retirement Benefits

Retirement benefits are important because they give financial support to employees after they stop working. In India, employers offer several types of retirement benefits. The most common ones are the Employee Provident Fund (EPF) and the National Pension System (NPS), which are savings schemes where both the employee and employer put in money regularly to build a retirement fund. Employees also receive gratuity, which is a lump sum paid for their service, and they can encash their unused leave when they retire. If an employee is eligible for a pension, they may get a part of it upfront as a commuted pension. In cases where an employee chooses voluntary retirement or is asked to leave due to retrenchment, they may receive additional compensation. The taxability of these retirement benefits under the Income-tax Act is as follows:

Gratuity
An employer must pay gratuity to an employee who has worked continuously for at least five years and leaves the company because of retirement, resignation, or superannuation. In cases where the employee dies or becomes disabled, the employer must pay gratuity even if the five-year rule is not completed. The taxability of gratuity will be as under:
For tax purposes, any gratuity received while still in service is fully taxable. Gratuity received at retirement is fully tax-free for government employees (other than employees of statutory corporations)

For employees who are covered under the Gratuity Act, 1972, the death-cum-retirement gratuity they receive is tax-free only up to a certain limit. The tax-free amount will be the lowest of these three:

(1) the amount calculated using the formula (*15/26) X last drawn salary X completed year of service or part thereof more than 6 months.

(2) Rs 20 lakh, or

(3) The actual gratuity received. For this calculation, “salary” means the last drawn basic pay plus dearness allowance (only the part that counts for retirement benefits), and it does not include bonus, commission, HRA, overtime, or any other allowances or perks. Any amount over the exempt limit becomes taxable.• For employees who are not covered under the Gratuity Act, 1972, and are not government employees, the tax exemption on death-cum-retirement gratuity is limited. The tax-free amount will be the lowest of three values:

(1) half a month’s average salary multiplied by the number of completed years of service,

(2) Rs 20,00,000, or

(3) the actual gratuity amount received. Here, “average salary” means the average of the employee’s basic pay and the part of dearness allowance that counts for retirement benefits, plus any turnover-based commission, taken for the last 10 months before retirement. Any gratuity received beyond the exempt limit becomes taxable.

Pension

Pension is the amount of money an employer gives to an employee after retirement or to the family after the employee’s death as a reward for the years of work they have completed. There are two types of pensions.

A. The first is commuted pension, which means the employee takes a lump-sum amount in advance by giving up a part of their monthly pension.

B. The second is an uncommuted pension, which is the regular monthly pension paid to the employee, just like a monthly salary after retirement.

• Uncommuted pension is fully taxable like regular income.
  Exception: Disability pensions of disabled armed forces personnel are fully tax-free.
• Family Pension (paid to family after employee’s death) is partly tax-free; one-third of the family pension or up to Rs 15,000 (whichever is less) is exempt.
  Exception: For families of armed forces personnel, the entire family pension is tax-free.
• A commuted pension received by an employee of government employees (Central/State/Local Authority/Statutory Corporation) is fully tax-free.
• Other employees who also receive gratuity: One-third of the commuted pension is tax-free.
• Other employees who do not receive gratuity: One-half of the commuted pension is tax-free.

Leave Enhancement Salary
Employees are given different types of leave that they can use for emergencies, personal work, or vacations. If an employee does not use these leaves, the employer’s rules decide what happens next—some leaves may expire, some may be paid out at the end of the year, and some may be carried forward to the next year. Over time, employees may build up unused leave in their account. They can either use these accumulated leaves while still working or choose to receive money for them when they retire or resign. When an employee gives up their unused leave in exchange for payment, it is known as leave encashment. The taxability of leave encashment is as follows:

• Received during the period of service is fully taxable.
• Received on the death of the employee is tax-free
• Encashment of unutilised earned leave at the time of retirement of government employees is tax-free.
• When an employee retires and receives money for their unused earned leave, a part of this amount can be tax-free. For non-government employees, the exempt amount is the lowest of four values: (a) The actual leave encashment received
  (b) The unutilised earned leave multiplied by the average monthly salary
  (c) ten months’ average salary, or (d) Rs 25,00,000

(While calculating unused leave, the law allows a maximum of 30 days of earned leave per year of service, even if the employer has granted more. Average salary is the last ten months immediately preceding the retirement. Salary is equal to basic pay + dearness allowance + turnover-based commission.)

Voluntary Retirement Scheme

Voluntary retirement is an option given by employers that allows employees to retire earlier than the normal retirement age. To support employees who choose this option, the employer pays them a lump-sum amount called voluntary retirement compensation. Normally, this payment is taxable like any other income received instead of a salary. However, the Income-tax Act provides relief under Section 10(10C), which allows a part of this compensation to be tax-free. The amount that is exempt from tax is limited to the lowest of the specific limits prescribed in the law.

(a) Compensation received or

(b) Rs 500,000

Exemption is allowed only if the following conditions are met:

• The voluntary retirement compensation must be paid by an employer who is allowed to offer such a scheme.
• The scheme should genuinely reduce the number of employees in the organisation.
• The employee must have completed 10 years of service or be at least 40 years old (not required for public sector company employees).
• The company must not hire someone else to fill the position of the employee who took voluntary retirement, and the retiring employee cannot join another company under the same management.
• The employee must not have claimed a tax exemption for voluntary retirement in the past.
• The compensation amount must not exceed either three months’ salary for each completed year of service or the salary for the remaining months left until normal retirement, whichever is lower.
• For this calculation, “salary” means the last drawn basic salary + the part of the dearness allowance counted for retirement benefits + any commission received.
• The scheme must be available to all employees (workers and executives), except company directors or directors of co-operative societies.
• The employee must not claim Section 89 relief on the voluntary retirement amount.

Retrenchment Compensation

Retrenchment compensation is the amount paid to a worker when their job is terminated because the company no longer needs their position. Under the Industrial Disputes Act, 1947, or any similar law, this compensation is tax-free up to Rs 500,000. The taxability of retrenchment compensation is as follows:

Payment of compensation under a scheme approved by the central government is tax-free.

Payment of compensation on the closure of the undertaking due to the losses. Lower of the following is exempt:

• (a) Rs 500,000
• (b) Retrenchment compensation actually received
• (c) Average wage: 15/26 completed years of continuous service or any part thereof in excess of 6 months.

Payment of compensation on the closure of the undertaking for any other reason beyond the control of the employer. Lower of the following is exempt:

• (a) Rs 5,00,00
• (b) Retrenchment compensation actually received.
• (c) Average wage of three months.

Provident Fund

The Employee’s Provident Fund (EPF) is a retirement savings scheme for people who earn a salary. Every month, you and your employer both put some money into your EPF account. This money keeps growing because it also earns interest.

Most of the time, the money you put in, the interest you earn, and the money you take out later are not taxed. But in a few special cases, some tax may apply. Tax treatment in respect of contributions made to and payments from various provident funds is summarized below:

• Employer’s contribution under Recognised Provident Fund (RPF) is up to 12% of basic salary + DA is tax-free. But it can be taxable in these two cases:
  (a) Any contribution above 12%.
  (b) Any contribution above Rs 750,000.
• Employer contribution under Statutory Provident Fund (SPF) is not applicable. whereas under the Unrecognized Provident Fund (UPF), it is not taxable.
• An employee’s contribution is eligible for deduction under Section 80C under Recognised Provident Fund (RPF) and Statutory Provident Fund (SPF). However, it is not eligible for deduction under Section 80C.
• Interest earned on PF under the Recognised Provident Fund (RPF) is exempt from tax. But it will be taxable in the following two scenarios:
  (a) Interest above the notified rate
  (b) Interest relating to the employee’s contribution above Rs 5 lakh, in case no contribution is made by the employer
  (c) Interest relating to the employee’s contribution above Rs 2.5 lakh, in case the employer has also contributed to the fund.
• Interest earned on PF under Statutory Provident Fund (SPF) is exempt from tax. But it will be taxable in the following scenarios:
  (a) Interest relating to the employee’s contribution above Rs 5 lakh, in case no contribution is made by the employer
  (b) Interest relating to the employee’s contribution above Rs 2.5 lakh, in case the employer has also contributed to the fund, whereas it is not taxable at the time of accrual under the Unrecognized Provident Fund (UPF).
• Withdrawal after 5 years under the Recognised Provident Fund (RPF) and Statutory Provident Fund (SPF) is exempt from tax. Whereas under the Unrecognised Provident Fund (UPF), the total of the following will be taxable:
  (a) Employer’s contribution
  (b) Interest on employer’s contribution and
  (c) Interest on employee’s contribution.
• Withdrawal 5 years before under the Recognised Provident Fund (RPF) is calculated as if the fund were not recognised from the beginning. Withdrawal 5 years under the Statutory Provident Fund (SPF) is exempt. Whereas, under the Unrecognized Provident Fund (UPF), the following is taxable:
  (a) Employer’s contribution
  (b) Interest on employer’s contribution and
  (c) Interest on employee contributions.

National Pension System (NPS)

The National Pension System (NPS) is a government-regulated retirement savings plan managed by the PFRDA. The money you invest in NPS is collected in your pension account and handled by professional fund managers, who invest it in a mix of government bonds, corporate bonds, shares, and other secure options. Over time, your savings grow based on the returns earned from these investments. In simple words, NPS helps you slowly build a pension fund for your retirement by investing your money wisely.

1. When you put money into NPS (Contributions)

A. Employees’ contribution to NPS

The tax deduction is up to 10% of salary (Basic + Additional deduction).

B. If the employer contributes to NPS

The deduction is allowed up to:

• For Govt employees: Up to 14% of salary
• For Other employees: Up to 10% of salary
• If an employee is using the new tax regime, the employer contribution limit is 14% for everyone.
  (The benefit of additional deduction of up to Rs 50,000 under section 80CCD(1B) is also available to sums deposited to the account of a minor by a parent or guardian, effective from AY 2026-27.)

C. For any other person not being an employee, the deduction is allowed up to 20% of gross total income plus an additional deduction of Rs. 50,000.

2. Accumulation
(a) Yearly return on the corpus amount is tax-free.

3. Withdrawal

(a) Partial Withdrawal

If an employee takes a partial withdrawal from their NPS account before retirement, they don’t have to pay any tax on the amount they withdraw, but only up to 25% of the total money that they themselves have deposited into NPS over the years.

(b) Final withdrawal at the time of closure of account or opting out of the scheme is exempt up to 60% of the total corpus available in the NPS account of the subscriber.

(c) The Amount received by the nominee on the death of the subscriber is fully exempt.

4. Pension Income

Pension received out of NPS, or annuity is fully taxable.