How Do Pension Plans Work in India?

With the ever-increasing expenses, inflation, elevated lifestyles and the growing inclination towards early retirement, pension planning has become more crucial than ever. It's a reliable means of securing financial stability during one's golden years.

Before aiming to build a secure future through these pension plans, it is highly imperative to understand how these plans function. Read on for details about pension plans and how they work to ensure a comfortable retirement.

A pension plan is a structured investment tool that enables individuals to save funds during their working years to secure income post-retirement. It serves as a financial safety net, ensuring a steady income stream during one's golden years.

The pension plans in India typically have two phases: 

1. Accumulation Phase

2. Vesting Phase

As discussed, pension plans have two phases: The Accumulation Phase and the Vesting Phase.

Here are the various steps involved in a pension plan: 

1. Enrolment in the Pension Plan

2. Contribution to the Pension

3. Accumulation of Pension Fund

4. Vesting of Pension

After a certain age or period of employment, individuals become vested in their pension plan. This means they have ownership rights to the funds of their pension plan. In the case of pension plans, the vesting age is the retirement age when the individual starts receiving their pension. 

On vesting, you have two options: start receiving the pension or withdraw your maturity corpus and invest in an immediate annuity. 

5. Distribution of Pension Payments

6. Tax-Deferred Growth

7. Death Benefit in Pension Plans

Some insurance-based pension plans may offer death benefits. Thus, a death benefit is paid to the beneficiary in case of the policyholder's unfortunate demise.

This death benefit depends on the kind of pension plan. Some plans provide a certain percentage of premiums paid, while others offer pension continuity to the beneficiary in case of the demise of the pension holder. 

1. National Pension Scheme (NPS)

2. Employee Provident Fund (EPF)

3. Annuity Plans

4. Atal Pension Yojna

5. Whole Life ULIP Plans

1. Earlier the Better

2. Vestige Age

3. Annuity Option

Choose the annuity option that is most aligned with your needs. If you are nearing retirement, you can opt for an immediate annuity. However, you can choose a deferred annuity if there is still time for retirement. Other annuity options include fixed, variable, joint life, and last survivor annuity. Choose an option most suited to your needs.

Read More: Difference Between Immediate Annuity & Deferred Annuity

4. Death Benefit Payout

The tax treatment varies depending on the type of pension plan and the manner of withdrawal (lump sum or annuity). It's essential to understand these nuances to plan for taxation efficiently.

Let's see how the different kinds of pension plans are taxed in India:

1. Commuted and Uncommuted Pension

In commuted pension, a portion of your accumulated pension fund is paid as a lumpsum on your retirement and the balance portion is paid as regular income. Here, the lumpsum payment is exempt from tax if you are a government employee and the regular income is taxed under the head ‘salaries.’

On the other hand, there is no lumpsum payment in uncommuted pension, and the complete corpus is paid as a regular income. These regular payouts are all taxable under the head ‘Income from Salaries.’

In the above case, if you are a non-government employee and are receiving gratuity along with pension, one third of the commuted pension will be tax free and the other two-third will be taxed as ‘salaries.’

However, if you are receiving only pension and no gratuity, half of your pension would be tax free and the other half will be taxable.  

2. Pension from Life Insurance Plans

3. Family Pension

4. TDS by Banks

Under section 194(P), banks deduct tax on senior citizens more than 75 years of age, who have only pension and interest income from the bank. They are also exempt from filing income tax returns.

We have discussed major heads of pension plans and how they are taxed. However, the taxation is as per the prevailing tax laws. These tax benefits are subject to change in tax laws. We therefore urge you to carefully analyse in consultation with your advisor the tax benefits/tax implications, if any that may arise on opting for this policy.

The pensioner utilises the pension funds as their regular source of income. However, on their death, the nominee can utilise the pension fund, which is paid as death benefit in the following ways:

1. Take the entire death benefit as lumpsum
2. Buy an immediate annuity plan with the death benefit payout
   
3. Withdraw the death benefit partially and use the remaining amount to buy an annuity plan.  

You can choose to surrender your pension plan anytime you wish to. However, in such cases, a discontinuation charge will be applied and deducted from your accumulated fund value.

The surrendered or discontinued fund will also earn an interest on 4% p.a. that you can withdraw after 5 years. If you surrender your pension fund within 5 years, the proceeds must be invested to buy an annuity plan.

Pension plans serve a crucial role for financial security in retirement, offering peace of mind through steady income streams. It is important to understand the types of pension plans and their features.

Hence, with timely investment in these plans, individuals can ensure a stable and comfortable retirement, safeguarding their future against economic uncertainties and enjoying their golden years worry free.