Taxability of Retirement Benefits

On retirement, an employee normally receives certain retirement benefits. Such benefits are taxable under the head ‘Salaries’. However, in respect of some of them, exemption from taxation is granted u/s 10 of the Income Tax Act, either wholly or partly. These exemptions  differs in the hands of central government employees, state government employees and private employees. Benefits along with their exemptions are described below.

 Types of retirement benefits

1. Gratuity
2. Leave Encashment
3. Pension or Annuity
   • Commuted pension
   • Un-commuted pension
4. Retrenchment Compensation
5. Voluntary Retirement Scheme ( VRS )
6. Provident Fund

 Gratuity (Section 10(10))

An employer is liable to pay gratuity to an employee who has completed 5 years of continuous services and his employment with the employer terminates due to retirement, resignation, or superannuation. However, in case of death or disablement of the employee, the employer is liable to pay the gratuity even if the employee does not complete 5 years of service. The taxability of gratuity shall be as under:

1. Gratuity Received by Government Employees : Any death cum retirement gratuity is fully exempt u/s 10(10)(i)
2. Other Employees (Non-Government)
   1. Covered by Payment of Gratuity Act,1972: Any death cum retirement gratuity is exempt from tax to the extent of least of following
      • Rs 20,00,000
      • Actual Gratuity received.
      • 15 days salary based on last drawn salary for each completed year of service or part thereof in excess of 6 months

Note: No of days per month to be taken as 26 days

2. Not covered by Payment of Gratuity Act, 1972: Any death cum retirement gratuity is exempt from tax to the extent of least of following
• Rs 20,00,000
• Actual Gratuity received
• Half month’s Salary (based on last 10 months average salary immediately preceding the month of retirement or death) for each completed year of service

Note 1: Gratuity received during the period of service is taxable.

Illustrations 

Mr. A retired on 28.7.2020 after completing 25 years and six months of service and received a gratuity of INR 15,00,000. During retirement, his salary was:

• Basic Salary: INR 40,000 p.m.
• Dearness Allowance: INR 15,000 p.m. (of which 60% is for retirement benefits)
• Commission: 1% of turnover (in the last 12 months, turnover was INR 1,20,00,000)
• Bonus: INR 30,000 p.a.

Computation of his taxable gratuity assuming:

(a) He is a Government employee.

(b) He is a private sector employee and covered by the Payment of Gratuity Act 1972.

 (c) He is a private sector employee and not covered by the Payment of Gratuity Act 1972.

Leave Encashment (Section 10(10AA))

Every organization gives leave to employees, which they can use for emergencies or vacations. If employees don’t use their leave, it may expire, be paid out at the end of the year, or carried over to the next year, based on the company’s rules. The leave that employees save up can be used while they are working or cashed out when they retire or resign. When leave is traded for money, it’s called 'leave encashment.' The tax rules for leave encashment are as follows:

1. Government Employees: Leave Encashment received at the time of retirement is fully exempt from tax.
2. Non-Government Employees: Leave Encashment received is exempt from tax to the extent of least of following.
• Rs 3,00,000 (W.e.f 1 st April 2023, this amount increase to 2500000/-)
• Actual Leave encashment received
• 10 months average salary
• Period of earned leave In months ( Leave allowed-leaven taken/30 days) * 10 months average salary

Note: Leave Encashment received during the period of service is taxable.

Note : Leave Encashment received on death is fully exempt from Tax.

Pension or Annuity

Pension is of 2 types i.e., Un commuted and Commuted Pension

1. Un commuted Pension: It means pension received periodically. It is fully taxable in the hands of both Government and Non-Government employees.
   
   
2. Commuted Pension: It means lumpsum amount taken by converting the future right to receive pension and receive the amount immediately
   
   • Employees of the Central Govt/local authorities/statutory corporation/members of civil services/defence services: Any commuted pension received is fully exempt from tax
   • Other employees: Any commuted pension received is exempt from tax in the following way
     
     
     • If gratuity is not received Commuted value of half of pension which he is normally entitled to receive.
     • If gratuity is also received Commuted value of 1/3rd of pension which he is normally entitled to receive.

Illustrations 

A retired on 15.04.2021 from B Company Ltd. He was entitled to a pension of Rs. 8,000 p.m. At the time of retirement, he got 75% of the pension commuted and received Rs. 2,40,000 as commuted pension. Compute the taxable portion of the commuted pension if-

(i) He is also entitled to gratuity.

(ii) He is not entitled to gratuity.

Solution

1. 75% of Commuted Pension is equal to Rs. 2,40,000. Hence commuted value of 1/3 of the pension would amount to Rs. 2,40,000*100/75 * 1/3 = Rs.1,06,667 ;
   Rs. 1,06,667 would, therefore, be exempt and balance Rs.1,33,333 would be taxable.
2. 75% of Commuted Pension is equal to Rs. 2,40,000. Hence commuted value of 50% of the pension would amount to Rs. 2,40,000*100/75 * 1/2 = Rs.1,60,000.
   Therefore, Rs. 1,60,000 would be exempt and Rs. 80,000 would be taxable.

Retrenchment Compensation

Retrenchment compensation is a financial payout provided to employees who are laid off by their employer due to downsizing, restructuring, or other economic reasons. This compensation serves as a form of financial support to help the affected employees manage their expenses while they search for new employment.

Retrenchment compensation received by a workman under the Industrial Disputes Act, 1947 or any other Act or Rules is exempt subject to following limits:-

1. Compensation calculated @ 15 days average pay for every completed year of continuous service or part there of in excess of 6 months. 
2. The above is further subject to an overall limit of Rs.5,00,000 for retrenchment on or after 1.1.1997

Voluntary Retirement Scheme ( VRS )

Payment received by an employee of the following at the time of voluntary retirement, or termination of service is exempt to the extent of Rs. 5 Lakh:

1. Public Sector Company.
2. Any other company.
3. Authority established under State, Central or Provincial Act.
4. Local Authority.
5. Co-operative Societies, Universities, IITs and Notified Institutes of Management.
6. Any State Government or the Central Government.
   
   NOTE : VRS received by any other employees is fully taxable.

Provident Fund:

Provident Fund Employee’s Provident Fund (EPF) is a retirement benefit scheme that’s available to salaried employees. Contribution in EPF is made both by the employee and the employer. The contribution, earning, and withdrawals from the EPF account are exempt from tax except in certain circumstances.

Tax treatment in respect of contributions made to and payments from various provident funds are summarized below: