How are your NPS Tier II withdrawals taxed?

The National Pension System (NPS) has two types of accounts: Tier I and Tier II. The Tier I account is the main account and is mandatory, while opening a Tier II account is optional. The Tier II account is like a savings account where you can deposit and withdraw money as you wish. You can transfer money from a Tier II account to a Tier I account at any time and not the other way around. All subscribers are eligible for tax breaks on contributions to Tier I accounts, but tax breaks on Tier II accounts are only available to central government employees with a three-year vesting period. Since there is no specific legal provision for taxing withdrawals from Tier II accounts, I thought I will try to explain how to logically tax such withdrawals.

Are withdrawals from the Tier II account taxable?

According to Section 10 (12A) of the Income Tax Act, 60% of the amount withdrawn from the account specified in Section 80 CCD when the account is closed or at the time of deregistration is tax-free in the hands of the subscriber. Likewise, in the case of partial withdrawals, 25% of the subscriber’s contribution from the account mentioned in Section 80 CCD according to Section 10 (12B) is tax-free. The implicit section 80 CCD only relates to the Tier I account, as the deduction under this section is only possible for contributions to the Tier I account and not for contributions to the Tier II account for which a deduction in accordance with section 80C (2) (xxv) is possible.

There is no specific and direct provision for taxing the withdrawal of Tier II accounts under the Income Tax Act. If tax law does not contain specific provisions for the taxation of an item, it will not become tax-free or taxable by default. In such a situation one has to apply logic and use other provisions of the same law. The full value of the money withdrawn from the Tier II account cannot be taxed as the legislature would not have considered taxing anything at the time of the withdrawal if a tax advantage was never claimed when the money was deposited. However, this does not mean that the entire amount withdrawn is tax-free. Withdrawals from the Tier II account are like normal withdrawals from your savings account and are not taxed except for the interest earned.

To get to the logical rules for taxing Tier II account withdrawals, I rely on the provisions of Section 80CCC. Section 80CCC (1) provides for the deduction of the premium paid for the purchase of an annuity. Section 80 CCC (2) provides for the taxation of the surrender value of such a policy, which restricts taxation to the extent that the tax advantages under Section 80 CCC (1) have been used by the natural person and not beyond this, with exception the increase in the system. The same logic must be applied here.

How the withdrawals should logically be taxed

For the reasons outlined above, I firmly believe that all of the money withdrawn from the Tier II account cannot be taxed with all imagination. What can and should be taxed logically is the possible increase in the value of the investments that is included in the withdrawals.

Since investments in Tier II accounts do not have a fixed rate of return such as time deposits or bonds or notes, the appreciation of the investments cannot be taxed under the heading “Income from Other Sources”. As a subscriber, shares are allocated for his investments in various categories of funds such as stocks, corporate bonds and government bonds at their net asset value (NAV) at the time of investment, it is logical to treat contributions to the Tier II account as investments and all profits therefrom as Capital to handle profits.

Since an investment in NPS cannot be referred to as listed stocks or treated as shares in equity funds, it will not become long-term until the shares are sold after 36 months. Since no securities transaction tax (STT) is paid at the time of repayment, it cannot be taxed as a share-based system in accordance with Section 112A in relation to the equity component either. After indexing, it is taxed at a flat rate of 20% if it is held for more than 36 months. If the shares are redeemed within 36 months, the redemption gains should be treated as short-term capital gains and included in your regular income, which is taxed at the flat rate applicable to your total income.

The difference between the NAV of the purchase and the redemption must be multiplied by the number of shares used for redemption to obtain the profit realized on redemption of a particular transaction.

Please note that what I have mentioned, in the absence of specific and direct provisions in the Income Tax Act, is not the exact legal position, but is exclusively my opinion, which was obtained with the help of common sense and logic. Given the confusion surrounding the withdrawal tax for Tier II accounts, it is the duty of the state to clarify the legal situation as early as possible. This will help many people make the decision to take advantage of the low cost investment option of the Tier II account.

Balwant Jain is a tax and investment professional and can be reached at [email protected]

Subscribe to something Mint newsletter

* Please enter a valid email

* Thank you for subscribing to our newsletter.

Never miss a story again! Stay connected and informed with Mint. Download our app now !!