Taxability of Retirement Benefits

Retirement benefits play a crucial role in providing financial security to employees in their
post-retirement years. In India, employers provide various retirement benefits to employees.
The most common retirement benefits offered by employers in India include the Employee
Provident Fund (EPF) and the National Pension System (NPS), both of which are savings
schemes that allow employees to accumulate a portion of their salary, along with a matching
contribution from their employer. Additionally, employees are entitled to receive gratuity, a
lump sum payment made as a token of appreciation for their service, and leave encashment on
their retirement. If an employee is eligible for a pension, he may also receive the commuted
pension. If an employee is voluntarily retired or retrenched, he may be entitled to voluntary
retirement compensation or retrenchment compensation. The taxability of these retirement
benefits under the Income-tax Act is as follows:
Gratuity
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:
Particulars Taxability

Gratuity received during service Fully Taxable

Gratuity received at the time of retirement

Gratuity received by Government Employees Fully Exempt

(Other than employees of statutory
corporations)

Death -cum-Retirement gratuity received by Least of the following amount is exempt

other employees who are covered under from tax:
Gratuity Act, 1972 (other than Government
1. (*15/26) X Last drawn salary** X
employees) (Subject to certain conditions). completed year of service or part thereof in
excess of 6 months.
2. Rs. 20,00,000
3. Gratuity actually received.
*7 days in case of an employee of a
seasonal establishment.
** Salary = Last drawn salary including DA
but excluding any bonus, commission,
HRA, overtime, and any other allowance,
benefits, or perquisite

Death -cum-Retirement gratuity received by Least of the following amount is exempt

other employees who are not covered under from tax:
Gratuity Act, 1972 (other than Government 1. Half month’s Average Salary* X
employees) (Subject to certain conditions). Completed years of service

[As amended by Finance Act, 2 0 23]

 2. Rs. 20,00,000
3. Gratuity actually received.
*Average salary = Average Salary of the
last 10 months immediately preceding the
month of retirement
** Salary = Basic Pay + Dearness
Allowance (to the extent it forms part of
retirement benefits)+ turnover-based
commission
Pension
Pension is a payment made by the employer after the retirement/death of the employee as a
reward for past services. There are two kinds of pension:-
(a) Commuted Pension - Commutation of pension means immediate payment of the lump-
sum amount to an employee in lieu of surrender of a portion of the monthly pension.
(b) Uncommuted Pension - When the pension is paid on a periodical basis, it is called an
uncommuted Pension.
The tax treatment of pension shall be as under:
Particulars Taxability

Uncommuted Pension Fully Taxable. However, disability pension

payable to disabled armed forces personnel
shall be exempt from tax.

Family Pension 33.33% of Family Pension subject to a

maximum of Rs. 15,000 shall be exempt
from tax. However, the family pension
received by the family members of the
armed forces shall be fully exempt from
tax.

Commuted pension received by an employee of Fully Exempt

the Central Government, State Government,
Local Authority, and Statutory Corporation

Commuted pension received by other 1/3 of the full value of commuted pension
employees who also receive gratuity will be exempt from tax

Commuted pension received by other 1/2 of the full value of commuted pension
employees who do not receive any gratuity will be exempt from tax
Leave Encashment Salary
Every entity provides leaves to the employees, which can be availed of by them in emergency
situations or for vacations. If these leaves are not availed of by them, they may lapse or are
encashed at the year-end or are carried forward to next year, as per the service rules of the
employer. The accumulated leaves standing to the credit of an employee may be availed of by
the employee during the tenure of employment or may be encashed at the time of retirement or
resignation. When leaves are surrendered in lieu of monetary consideration, it is known as
'leave encashment'. The taxability of leave encashment shall be as under:

[As amended by Finance Act, 2 0 23]

 Particulars Taxability

Received during the period of service Fully Taxable

Received on dealth of the employee Fully Exempt

Received on retirement, whether on

superannuation or otherwise

Encashment of unutilized earned leave at the Fully Exempt

time of retirement of Government employees

Encashment of unutilized earned leave at the Least of the following shall be exempt from
time of retirement of other employees (not tax:
being a Government employee) a) Amount actually received
b) Unutilized earned leave* X Average
monthly salary
c) 10 months Average Salary**
d) Rs. 3,00,000
*While computing unutilized earned leave,
earned leave entitlements cannot exceed 30
days for each year of service rendered to the
current employer
**Average salary = Average Salary*** of
the last 10 months immediately preceding
the retirement
***Salary = Basic Pay + Dearness
Allowance (to the extent it forms part of
retirement benefits)+ turnover-based
commission
Voluntary Retirement Scheme
Voluntary retirement is an early retirement option given by an employer to its employees to
take retirement before the decided age of retirement. To ensure social security for the retiring
employees, employers provide 'voluntary retirement compensation' to its employees. Such
compensation is taxable in the hands of the employees as profit in lieu of salary. However,
exemption under Section 10(10C) is allowed to the extent of lower of the following:
(a) Compensation received; or
(b) Rs. 500,000.
The exemption is allowed subject to the following conditions:-
(a) The voluntary retirement compensation is paid by the specified category of employer.
(b) The scheme should be drawn to result in an overall reduction in the existing strength of
the employees.
(c) The employee has completed 10 years of service or completed 40 years of age. (This
condition is not applicable in the case of employees of a Public Sector Company).

[As amended by Finance Act, 2 0 23]

(d) The vacancy caused by the voluntary retirement is not re-filled by any other new hiring.
Moreover, the retiring employee must not be employed in any other company or concern
of the same management.
(e) The employee has not availed of any tax exemption in respect of voluntary retirement
compensation in the past.
(f) The amount of compensation does not exceed 3 months’ salary for each completed year
of service or salary for the remaining period of employment left before such retirement.
'Salary' for this purpose shall be the total of last drawn basic salary, dearness allowance
(if forms part of salary for computing retirement benefits), and commission paid to the
employee.
(g) The scheme should apply to all employees, including workers and executives of a concern
excluding directors of a company or a co-operative society.
(h) Employee should not claim relief under Section 89 in respect of such compensation.
Retrenchment Compensation
Retrenchment Compensation received by a workman under the Industrial Dispute Act, 1947,
or any other law for termination of his employment is exempt from tax up to Rs. 5,00,000.
The taxability of retrenchment compensation is as follows:
Particulars Taxability

Payment of compensation under a Scheme Fully Exempt

approved by the Central Government

Payment of compensation on the closure of the Lower of the following is exempt:

undertaking due to the losses (a) Rs. 5,00,000.
(b) Retrenchment compensation actually
received.
(c) Average wage * 15/26 * completed year
of continuous service or any part thereof
in excess of 6 months.

Payment of compensation on the closure of the Lower of the following is exempt:

undertaking for any other reason beyond the (a) Rs. 5,00,000.
control of the employer (b) Retrenchment compensation actually
received.
(c) Average wage of three months.
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 in the table given below:
Treatment of Recognised Provident Statutory Provident Unrecognised
Fund (RPF) Fund (SPF) Provident Fund (UPF)

[As amended by Finance Act, 2 0 23]

Employer's Contribution up to 12% of - Not Taxable
Contribution basic salary + DA is
exempt from tax. However,
it shall be taxable in the
following two scenarios:
(a) Any contribution above
12%;
(b) Any contribution above
Rs. 7,50,0001.
Employee's Eligible for deduction Eligible for deduction Not eligible for
Contribution under Section 80C under Section 80C deduction under
Section 80C
Interest Exempt from tax. Exempt from tax. Not taxable at the time
earned on However, it shall be However, it shall be of accrual
PF taxable in the following taxable in the following
two scenarios: scenarios:
(a) Interest above the (a)Interest relating to
notified rate; the employee's
(b) Interest relating to the contribution above
employee's Rs. 5 lakh, in case
contribution above Rs. no contribution is
5 lakh, in case no made by employer;
contribution is made by (b)Interest relating to
employer; the employee's
(c) Interest relating to the contribution above
employee's Rs. 2.5 lakh, in case
contribution above Rs. employer has also
2.5 lakh, in case contributed to the
employer has also fund.
contributed to the fund.
Withdrawal Exempt from tax Exempt from tax Aggregate of the
after 5 years following shall be
taxable:
(a) Employer's
contribution;
(b) Interest on
employer's
contribution; and
(c) Interest on
employee's
contribution

1
The excess contribution shall be taxable only if the aggregate amount of contribution made by the
employer to the account of employee in a Recognised Provident Fund, National Pension Scheme and
Superannuation Fund exceeds Rs. 7,50,000. In this situation, the excess amount so contributed is
taxable as perquisite in the hands of employee.

[As amended by Finance Act, 2 0 23]

Withdrawal Total income is computed Exempt Aggregate of the
before 5 as if the fund is not following shall be
years recognised from the taxable:
beginning. (a) Employer's
contribution;
(b) Interest on
employer's
contribution; and
(c) Interest on
employee's
contribution

National Pension System (NPS)

National Pension System (NPS) is a retirement savings scheme administered and regulated by
Pension Fund Regulatory and Development Authority (PFRDA). Under the NPS, individual
savings are pooled into a pension fund which is invested by PFRDA regulated professional
fund managers as per the approved investment guidelines into the diversified portfolios
comprising of government bonds, bills, corporate debentures and shares. These contributions
would grow and accumulate over the years, depending on the returns earned on the investment
made.
The tax treatment of the contribution made to the NPS, accumulation of return and the amount
withdrawn from the NPS is as follows:
Particulars Taxability
Contribution to NPS
(a) Employees’ contribution to NPS The deduction is allowed up to 10% of
salary plus additional deduction of Rs.
50,000.
(b) Employers’ contribution to NPS* The deduction is allowed up to:
 14% of salary in case of Central
Government or State Government
employees;
 10% of salary in case of other
employees.
(c) Any other person not being an employee The deduction is allowed up to 20% of
gross total income plus additional
deduction of Rs. 50,000.
Accumulation
Yearly return on the corpus amount Tax-free
Withdrawal
(a) Partial withdrawal In subscriber is an employee, exempt to
the extent of 25% of the contribution
made by the employee to the NPS.

[As amended by Finance Act, 2 0 23]

(b) Final withdrawal at the time of closure of Exempt up to 60% of the total corpus
account or opting out of the scheme available in the NPS account of the
subscriber.
(c) Amount received by the nominee on death Fully exempt
of subscriber
Pension Income
Pension received out of NPS or annuity Fully Taxable

[As amended by Finance Act, 2 0 23]

 MCQs on Taxability of retirement benefits

Q1. An employer is liable to pay gratuity to an employee who has completed ________
and his employment with the employer terminates due to retirement, resignation, or
superannuation.
(a) 5 years of continuous service
(b) 2 years of continuous service
(c) 1 year of continuous service
(d) 10 years of continuous service
Correct answer – (a)
Explanation: 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.
Q2. Gratuity received by an employee during his service is ________.
(a) Fully taxable
(b) Fully exempt
(c) Exempt to the extent of Rs. 10 lakhs
(d) Exempt to the extent of Rs. 20 lakhs
Correct answer – (a)
Explanation: Gratuity received by an employee during his service is fully taxable.
Q3. When the pension is paid on a periodic basis, it is called ________.
(a) Commuted pension
(b) Uncommuted pension
Correct answer – (b)
Explanation: When the pension is paid on a periodical basis, it is called an uncommuted
Pension.
Q4. Commuted pension received by an employee of the Local Authority is fully exempt.
(a) True
(b) False
Correct answer – (a)
Explanation: Commuted pension received by an employee of the Central Government, State
Government, Local Authority, and Statutory Corporation is fully exempt.
Q5. Leave encashment received on the death of the employee is fully taxable.
(a) True
(b) False
Correct answer – (b)
Explanation: Leave encashment received on the death of the employee is fully exempt.
Q6. What is the maximum amount allowed as exempt under section 10(10C) in respect of
voluntary retirement compensation?
(a) Compensation received

[As amended by Finance Act, 2 0 23]

(b) Rs. 5,00,000
(c) Lowed of (a) and (b)
(d) Higher of (a) and (b)
Correct answer – (c)
Explanation: Exemption under Section 10(10C) is allowed to the extent of lower of the
following:
(a) Compensation received; or
(b) Rs. 500,000.
Q7. What is the maximum amount allowed as exempt in respect of retrenchment
compensation received on the closure of undertaking due to the losses?
(a) Retrenchment compensation received
(b) Rs. 5,00,000
(c) Average wage * 15/26 * completed year of continuous service or any part thereof in excess
of 6 months.
(d) Lowed of (a), (b), and (c)
Correct answer – (d)
Explanation: Lower of the following is exempt where retrenchment compensation received by
the employee on the closure of the undertaking due to the losses:
(a) Rs. 5,00,000.
(b) Retrenchment compensation actually received.
(c) Average wage * 15/26 * completed year of continuous service or any part thereof in
excess of 6 months.
Q8. Whether employee’s contribution to the Unrecognised Provident Fund is allowed as
a deduction under Section 80C?
(a) Yes
(b) No
Correct answer – (b)
Explanation: Employee’s contribution to the Unrecognised Provident Fund (UPF) is not
allowed as a deduction under Section 80C.
Q9. Pension received out of annuity is ________.
(a) Fully taxable
(b) Fully exempt
(c) Partially taxable and partially exempt
Correct answer – (a)
Explanation: Pension received out of NPS or annuity is fully taxable.

[As amended by Finance Act, 2 0 23]