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Tuesday, February 22, 2011

How to reduce tax on your retirement benefits

Perhaps one of the most ignored challenges after retirement is to manage your benefits. Ironically, you are anxious about everything else: the sharp fall in income, life without colleagues, lack of drive, and so on. But for obvious reasons, you are excited about the benefits—provident fund, gratuity, leave encashment, superannuation fund, etc.

However, not all these returns are exempt from tax. So, it is important to distinguish the ones that are tax-free from those that are not. You should also be aware of ways to steer clear of such tax ‘traps’.

If you are a government employee, there can be a marked difference in the way your funds are taxed. “There is tax exemption on certain receipts such as commuted pension, gratuity, leave encashment, etc.

Private sector employees are generally taxed on the basis of prescribed rules,” says Suresh Surana, founder of RSM Astute Consulting, which offers specialised accounting and auditing services. Let’s take a look at the taxable and tax-free benefits and learn how to reduce your burden.

Provident fund:
It is completely tax-free. However, ensure that your office invests it in a recognised provident fund. “Unrecognised provident funds have different tax structures compared with the recognised ones. Further, the employer’s contribution and interest credited to such funds are taxable as income in the year of receipt,” says Surana.

When it comes to the Employee Provident Fund (EPF), the interest and amount paid at retirement are not tax-free if your employer had been contributing more than 12% of your salary to the account. Similarly, the interest “credited in excess of 9.5% per annum is included in gross salary”, says Ameet Patel, partner, Sudit K Parekh.

The benefits of working continuously for five years with an organisation are widely known. “The payment of accumulated balance from a recognised provident fund (RPF) is taxable unless the employee has worked continuously with a firm for five years,” says Sandeep Shanbhag, director at tax and investment advisory firm Wonderland Consultants.

However, if you know you are going to retire in less than five years of joining a new company, you can secure tax-free RPF on retirement by making sure you transfer the EPF account from the previous company to the current one. Gratuity: This is one corpus where government employees have an edge over others.


“Gratuity is a lump-sum payment made by an employer for long and meritorious service rendered by an employee,” says Surana. Any amount that the government employees receive is exempt from tax, but there is a cap for non-government staffers. For employees covered under the Payment of Gratuity Act, the cap is the least of the following: a) actual amount received b) 15 days’ salary for each year of service c) Rs 10 lakh.

“The salary for 15 days is calculated by dividing your last drawn salary by 26, which is the maximum number of working days in a month,” says Surana.

There could still be situations when you end up paying tax on gratuity. “Any gratuity received by an employee who is covered under the Payment of Gratuity Act and has worked for less than five years is fully taxable,” says Shanbhag. The clause, ‘completion of the five years’ service’ is not applicable in the case of death or disablement of an employee. Also, employees who are not covered under the Act do not have to complete five years of service to get tax-free gratuity.

Superannuation fund:
The amount received as superannuation is exempt from tax if it is paid on death, retirement, in lieu of or as annuity. “Any commutation of pension is exempt up to one-third of the commuted value of pension, where the employee receives any gratuity and half of such value otherwise,” says Shanbhag.

The interest that is accumulated on the superannuation fund is taxed under certain circumstances. “This exemption is not available if the employee resigns,” says Shanbhag.

“The escape route in cases where the amount becomes taxable is to purchase SAF (state annuity fund)-related annuity without any commutation. If you don’t do this, TDS (tax deducted at source) will be applicable on the average rate at which the employee was subject to during the preceding three years or during the period, if it is less than three years, when he was a member of the fund,” notes Shanbhag. The rest of the amount is exempt from tax only if annuities are purchased from life insurance companies.
Leave encashment: “The tax treatment of leave encashment depends on the status of the employee as well as the point at which the leave is encashed, that is, during employment or at the time of retirement,” says Surana. Leave encashment during the period of employment is taxed, but not at the time of retirement or leaving a job, adds Surana.

Any amount received as leave encashment by the state or central government employees is exempt from tax . However, the bar is stricter when it comes to others. The amount of encashed leave that is exempt from tax is the lower of Rs 3 lakh and the amount paid according to a calculation specified by the Income Tax Act.

“The taxable portion of leave encashment would form a part of the normal salary income and would be taxed as per the normal slab rate applicable to the employee. There is no special rate for this,” says Patel.

Voluntary Retirement Scheme:
“VRS is applicable only to those employees who have completed 10 years of service or are over 40 years of age,” says Surana. When you opt for the voluntary retirement scheme, the company will pay you a compensation, which is tax-free if it is lower of the two: Rs 5 lakh or the last three months’ average salary multiplied by the number of years of service. Beyond that, it is added to the income and taxed accordingly.

There are ways to avoid being slotted in the higher income tax bracket because of the hefty compensation paid in the year of retirement. “This exemption is also available if the VRS amount is paid in instalments spread over several years. Staggering this amount would mean that the employee not have to pay the entire tax upfront but is subjected to TDS as and when the instalments are paid,” says Shanbhag.

Moreover, employees will also benefit from the interest on the outstanding VRS amount at a rate much higher than the market rate and from a safe source: his erstwhile employer.


New Pension Scheme:
The central and state government employees who joined service in and after January 2004 are entitled to pension via the New Pension Scheme. Though they get tax benefits when they invest in this scheme, the amount they receive at maturity from this scheme is taxed. Also, the hefty bonus they get as golden handshake is fully taxable. “There is no exemption for such a payment,” says Patel. Any other amount that is not mandatory—that the employer pays of his own volition—is taxable.

The bottom line: the amount of tax you save on your retiral benefits will depend on how well-informed you are about the rules governing their taxation.

Curtesy: Economic Times

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