Taxation of the National Pension System

Tax treatment strongly influences how people save for retirement. The PFRDA Act does not deal with the taxation of subscribers; that is governed by the income tax law. From 1 April 2026, the Income-tax Act, 1961 has been replaced by the Income-tax Act, 2025, which renumbered the provisions on the NPS. This note explains the tax treatment of contributions, accumulation and withdrawals, using both the familiar old section numbers and the new ones where they are settled.

1. The Basic Model

Retirement savings may be taxed at three stages: contribution, accumulation (returns earned) and withdrawal. The NPS follows a broadly exempt-exempt-partly taxed pattern: contributions are deductible within limits, returns accumulate free of tax, and at exit part of the corpus is tax-free while the rest, including the annuity, is taxed. Its treatment has moved closer to full exemption over time.

2. Contributions

Employee or self-employed contribution

• Old law: Section 80CCD(1) allowed a deduction for the subscriber's own contribution up to 10 per cent of salary (basic pay plus dearness allowance), or 20 per cent of gross total income for the self-employed, within the overall ₹1.5 lakh limit shared with Section 80C.
• Additional deduction: Section 80CCD(1B) allowed a further ₹50,000 for NPS contributions, over and above the ₹1.5 lakh limit.
• New law: these deductions are now in Section 124 of the Income-tax Act, 2025, with the overall limit linked to Section 123 (the successor of Section 80C).
• Regime: these deductions are available only under the old tax regime, not under the default regime (now Section 202 of the new Act).

Employer contribution

• Deduction for the employee: the employer's contribution, included in the employee's salary, is deductible up to 14 per cent of salary where the employer is the Central or State Government, and 10 per cent for other employers under the old regime.
• Default regime: under the default regime, the deduction for employer contributions is available, and the limit for all employers is 14 per cent.
• New law: in Section 124 of the 2025 Act (formerly Section 80CCD(2)).
• Aggregate cap: employer contributions to the NPS, provident fund and superannuation funds above ₹7.5 lakh in a year are taxed as a perquisite.

Special cases

• NPS Vatsalya: contributions by a parent or guardian to a minor's account qualify for deduction within the additional ₹50,000 limit, as provided from 2025.
• Tax Saver Tier II: Central Government employees' contributions to the Tax Saver Tier II account qualify within the ₹1.5 lakh limit, subject to a three-year lock-in.
• Other Tier II: contributions to an ordinary Tier II account get no deduction.
• Unified Pension Scheme: the Government extended to the UPS the tax treatment available under the NPS.

3. Accumulation

Returns earned within the NPS are not taxed as they accrue. The income of the NPS Trust is exempt, so dividends, interest and capital gains on the investments compound without tax until withdrawal.

4. Withdrawals

• Lump sum at exit: up to 60 per cent of the corpus withdrawn on closure or exit is exempt (formerly Section 10(12A)). The exemption was introduced at 40 per cent in 2016 and raised to 60 per cent from 2019.
• The extra 20 per cent: after the December 2025 exit reforms allowed non-government subscribers to withdraw up to 80 per cent, commentators reported that the portion above 60 per cent remains taxable, because the income tax law had not been amended to match. The position should be checked against the current law.
• Partial withdrawal: withdrawals of up to 25 per cent of own contributions are exempt (formerly Section 10(12B)); the exemption is framed for employee subscribers.
• Annuity income: the pension received from the annuity is taxable as income in the year of receipt. The purchase of the annuity itself is not taxed.
• Death: the amount received by the nominee on the subscriber's death is not treated as income of the subscriber.
• Tier II: withdrawals from an ordinary Tier II account are taxed under general principles, as there is no specific exemption.

5. The Charging Mechanism

The income tax law deems the amount received on closure or opting out of the NPS, and the pension received from the annuity, to be income of the subscriber in the year of receipt (formerly Section 80CCD(3), now within Section 124). The specific exemptions above then remove the tax-free portions. The structure ensures that money which was deducted on contribution is taxed when it comes out, except to the extent Parliament has chosen to exempt it.

6. Policy Issues

• Parity with EPF: provident fund withdrawals are generally tax-free, which long made the NPS less attractive. The rise in the exempt lump sum to 60 per cent narrowed the gap.
• Annuity taxation: taxing annuity income, while exempting most of the lump sum, pushes subscribers away from annuities, which conflicts with the pension objective of the Act.
• Alignment with PFRDA's rules: when PFRDA changes withdrawal proportions, the tax law may lag, as shown by the extra 20 per cent after 2025.
• Default regime: with most personal deductions unavailable under the default regime, the employer contribution has become the main tax incentive for the NPS.

7. Related Topics and Provisions

• Exit, withdrawal and annuity under the NPS
• PRAN and Tier I and Tier II accounts
• The Unified Pension Scheme
• NPS versus EPF and PPF
• Annuities and the role of IRDAI