Commuted Pension: What is It and Its Taxability in India?

2024-08-01

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Commuted value of the pension is a confusing topic for the retired and families receiving a pension. Commuted pension is usually a choice between present financial needs and future financial status. You should know how commuted value affects your pension before raising the demand.

Structured financial planning is essential for determining the commuted value of the pension. It will help you handle your present financial needs without hurting your future prospects.

You need to have enough money to live the rest of your life in comfort. Post-retirement, you will need:

Regular Cash Flow: This helps you meet your daily and monthly expenses and lets you live by the same standard.
Lump-Sum Amount: For your medical expenses, deal with life's uncertainties and meet your retirement goals.

Hence, you must plan your pension and know everything about it.

Let us now understand what is commutation of pension.

Key Takeaways

A commuted pension allows retirees to receive a lump sum instead of part of their monthly pension, impacting long-term financial planning.
While a portion of the commuted pension may be tax-exempt, it is essential to understand tax regulations and determine if filing an Income Tax Return (ITR) is necessary.
Employees may be eligible for retirement or death gratuity benefits, which provide financial security to retirees or their families.
Assessing financial stability, healthcare costs, and potential risks of outliving savings is crucial before deciding to commute a pension.
Understanding the application status, policy details, and unclaimed amounts ensures a smooth pension commutation process.

Commuted Pension - Meaning

The simplest commuted pension means that while you work, you and your employer contribute to the annuity fund that pays your pension when you retire. You have two options to receive the accumulated amount when you retire:

As a monthly pension
Lump-sum amount paid in advance

The advance amount you receive as a lump sum against your pension is called commuted pension. For example, at 60 years of age, you want to go on a vacation with your family. For that, you will need a lump sum amount.

You decide to receive 20% of your monthly pension of ₹25,000 in advance for the next five years’ worth. The amount will be paid to you as a lump sum and will be calculated as:

20% of 25000*12*5 = Rs 3,00,000.

This amount is your commuted pension.

You can commute pension at retirement or during the retirement years. You can commute pension multiple times also.

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Retirement and Death Gratuity

The Payment of Gratuity Act 1972, applies to any establishment employing 10 or more employees or workers. The Act holds such firms to provide gratuity payments to the eligible employees upon retirement or death.

Retirement Gratuity: You are eligible to receive retirement gratuity when you voluntarily leave the service or retire. The eligibility criteria also include a minimum of five years of service with the organization. The gratuity will be equal to:
- 1/4th of Basic + DA as on the date of retirement for each completed six-monthly period of service.
- Maximum gratuity for government servants is limited to Rs 20 lakhs.
- There is no maximum limit for gratuity payment to employees of a private company. But the excess amount can be taxable.
Death Gratuity: Organizations providing gratuity benefits to their employees can pay gratuity amounts upon the death of an employee on duty. This is regardless of the length of the duty of the employee.

Death gratuity benefits from private employers depend on the gratuity plan opted by them. However, in any case, the minimum benefit from the plan will be as defined for government employees.

Death gratuity benefits for the family of government employees are as follows:

Qualifying Service	Gratuity Amount
Up to 1 year	2x basic pay
1 year to less than 5 years	6x basic pay
5 years to less than 11 years	12x basic pay
11 years to less than 20 years	20x basic pay
20 years or more	Lower of the following: Half of the emoluments for every completed 6 monthly periods of qualifying service 33x of emoluments

Did You Know?

The interest rate assumptions made have a major impact on the commuted value computation.

Source: Investopedia

Is Commuted Pension Taxable?

The taxability of commuted pension varies depending on your job category - government or non-government employee. The taxability for commuted pension works as below:

Government Employee	Non-Government Employee
For a government employee, the commuted pension is 100% tax exempted. You do not have to pay any tax.	For a non-government employee, there are two situations: Pension received along with gratuity: One-third of the commuted pension is exempted from tax, while the remaining two-thirds will be taxed like salary when received. Pension received without gratuity: 50% of your commuted pension is exempted from income tax.

Government Employee

Non-Government Employee

For a government employee, the commuted pension is 100% tax exempted. You do not have to pay any tax.

For a non-government employee, there are two situations:

Pension received along with gratuity: One-third of the commuted pension is exempted from tax, while the remaining two-thirds will be taxed like salary when received.
Pension received without gratuity: 50% of your commuted pension is exempted from income tax.

Learn how to build a tax-free pension income for retirement.

Do you Need to File ITR for Commuted Pension?

You will have to file ITR for the commuted pension you receive, and if it is higher than the limits allowed. The excess pension amount you receive in the given assessment year is fully taxable. You have certain tax relief under Section 89 of the Income Tax Act. However, to claim the benefits under Section 89, you need to file Form 10E.

You will have to report your commuted income while filing income tax returns. Follow the below steps to show your pension:

Under the salary schedule in the ITS, select the 'Pensioner' option in the field 'Nature of Employment'.
If you have received a pension as a salary, you will need to provide your employer's name, TAN, and address.
The part of income that is tax-exempt should be reported as a Commuted Pension. The remaining should come under 'Salary u/s 17(1)' as 'Annuity Pension'.

What if you Receive a Pension as a Family Member?

The taxation rules are different if the pension is received by a family member. Your income, in this case, is taxed under ‘Income from other sources’ in a family member's ITR. Below are the rules:

Pension received by family members of armed forces employees or UNO employees is tax-exempt.
Uncommuted pension received by an employee's family members is tax-exempt for up to one-third of the pension amount or Rs 15,000 in a given financial year (lower of the two).

For example, if a family member receives a pension of Rs 1.2 lakh in a financial year, the exemption available will be lower of two (Rs 15,000 or 1/3 of 1,20,000). Hence, your taxable income will be Rs 1.05 lakh.

Claiming Tax Exemptions on Commuted Pension

Pensioners can claim a deduction under Section 80C up to ₹1.5 lakh from their gross total income. Although after 60 you can claim up to ₹2 lakh under a few heads, most eligible expenses and investments allow up to ₹1.5 lakhs only. Below are some investment options to avail of tax exemption:

Equity Linked Saving Scheme (ELSS): You can invest in ELSS for higher returns. It comes with a lock-in of 3 years, and your investment gets exemption under Section 80C up to ₹1.5 lakh.
Fixed Deposits: You can invest in tax-saving fixed deposits. It comes with a lock-in of 5 years. If you are over 60 years old, most banks will give you additional interest on the fixed deposit account.
Unit Linked Insurance Plan (ULIP): This plan gives you dual benefits of insurance and investment options. A part of your investment goes towards insurance, and the balance is towards the investment bucket. The investment you make in a financial year (premium) is eligible for a tax deduction.
Pension Plan Investments: Even pension plans from life insurance companies are eligible for an 80C deduction on the invested money.
National Savings Certificates (NSC): NSC is also a safe investment, allowing you to claim a deduction at the time of investment. The accrued interest, however, will be taxable five years later.
Senior Citizens Savings Scheme: This is another great way to convert your taxable commuted pension into a tax-free amount. At the same time, you will also receive interest as cash flow from the deposit.

Learn more about the Senior Citizens Savings Scheme.

Thus, if you can plan for about three to five years, you can convert a taxable commuted pension to tax-free at a rate of ₹1.5 lakhs a year.

You can use a commuted value of pension to fulfil your retirement goals. The monthly pension you receive from your retirement savings is fully taxable. However, if you are just starting your retirement investments, you can use online ULIP plans to build a tax-free pension after 60.

Invest 4G is a ULIP plan from Canara HSBC Bank of Commerce life insurance and allows a holding period of up to 99 years of age. This means you can build a corpus from 30 to 60 or 65 and draw a tax-free lifetime pension after that. Additionally, upon your natural demise, the plan will pay higher of the sum assured or fund value to your nominees. Thus fulfilling another life goal for you – legacy.

You should only commute as much as you need to meet your retirement goals. It is equally important that you receive a decent monthly income to maintain the same living standards. With the above information, you know how commuted income is taxed and what is the tax exemption. You should take care of your commutation limits.

Factors to Consider Before Opting for a Commuted Pension

A commuted pension allows you to receive a lump sum amount instead of regular monthly payouts, significantly impacting your post-retirement financial situation. Therefore, it is crucial to evaluate your financial goals and requirements carefully to make an informed decision that aligns with your long-term plans.

Below are the essential factors to assess before choosing a commuted pension:

Adjusted Pension Income: Opting to commute a portion of your pension fund grants you immediate access to a lump sum, which can help address various financial needs. However, this choice affects your long-term income. It is vital to ensure that your financial security and goals remain stable despite the modification in your pension structure.
Financial Assessment: Assessing your overall financial position is the first step in deciding whether pension commutation is the right choice. Consider your current savings, other sources of retirement income, and both present and future financial needs to maintain a secure and stress-free retirement.
Tax Considerations: A part of the commuted pension is subject to taxation. To avoid unexpected financial burdens, review the applicable tax regulations to understand how pension commutation may impact your tax liability.
Healthcare Costs: With rising medical expenses, healthcare can become a significant financial strain during retirement. Before opting for a commuted pension, evaluate the increasing costs of medical care and ensure you have sufficient funds to cover future healthcare expenses without compromising your financial stability.
Longevity Risk and Financial Security: One of the primary risks associated with a commuted pension is the possibility of outliving your savings. Receiving a lump sum means foregoing a portion of the steady monthly pension, potentially reducing your long-term income. Market fluctuations and inflation could further impact your savings, leading to financial instability in later years. Proper financial planning is essential to prevent running out of funds during retirement.

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Advantages and Disadvantages of Commuted Pension

The various advantages of commuted pension are as follows:

Immediate Access to Funds: A lump sum payout provides financial flexibility to meet large expenses such as home loans, medical costs, or investments.
Investment Opportunities: The lump sum amount can be invested in high-return assets to generate additional income.
Debt Clearance: Helps in paying off outstanding loans, reducing financial burdens during retirement.
Liquidity for Emergencies: Provides a financial cushion for unforeseen expenses or urgent needs.

While commuted pensions do offer various advantages, it is not free of downsides and disadvantages. Some of its downsides are as follows:

Reduced Monthly Pension: Commuting a portion of the pension leads to lower regular income, which may impact long-term financial stability.
Tax Implications: A part of the commuted amount is taxable, affecting the net payout received.
Risk of Outliving Savings: If the lump sum is not managed wisely, there is a risk of depleting savings too soon.
Market Dependency: Investments made using the lump sum amount may be subject to market risks, leading to potential losses.

How to Calculate Commuted Pension

The steps to calculate a commuted pension are as follows:

Determine the Commutation Factor:- The commutation factor is prescribed by pension authorities and depends on age at the time of commutation.
Calculate the Commutable Portion:- Typically, a maximum of one-third (for government employees) or one-half (for others) of the pension can be commuted.
Apply the Formula:- Commuted Pension=(Monthly Pension×Commuted Portion×Commutation Factor)\text{Commuted Pension} = (\text{Monthly Pension} \times \text{Commuted Portion} \times \text{Commutation Factor})Commuted Pension=(Monthly Pension×Commuted Portion×Commutation Factor)
Deduct Applicable Taxes:- A portion of the commuted pension is taxable, depending on employment type and tax laws.
Final Pension Calculation:- The remaining pension after commutation is adjusted accordingly and continues as a reduced monthly payout.

Final Words

Fund emergencies can happen anytime, and you could need money right now. One practical way to overcome financial difficulties is to commute your pension plan. Commuted pension sums are subject to taxes. Therefore, before choosing such an option, consider the amount of money you want to remove in one lump payment and the tax exemption limits. Furthermore, to sustain your standard of living after retirement, you should have a sizable corpus.

Glossary:

Emoluments: Generally employed in a legal context, an emolument is payment for employment, services, or holding office determined by the duration and time of the action.
Accrued Interest: The amount of interest accrued as of a particular date on a loan or other financial obligation but has not yet been paid out is referred to as accrued interest.
Annuity Pension: An annuity plan offers a lifetime income stream upon making an initial lump sum deposit. You can select from a variety of payment choices to meet your unique retirement requirements.

FAQs Related to Commuted Pension

The pension you would normally get as a lifetime payment upon retirement as a lump amount is a commuted value. The commutation of the pension calculation formula is as follows:

Commuted Value (CVP) = 0.4(Maximum) x P x CF x 12. where, P = Pension Ordered. CF = Commutation Factor.

Government employees are fully exempt from income tax on their commuted pension. A third of the commuted pension amount is tax-exempt, with the remaining portion being taxable for non-government employees who get both pension and gratuity.

A government employee may commute up to 40% of their base pension in one lump sum payment under Rule 5 of the CCS (Commutation of Pension) Rules, 1981.

Rule 10 provides that the applicant will receive the difference between the authorised and increased commuted pension if the government modifies or increases a pensioner's benefits after commutation.

The money withdrawn from an employee provident fund (EPF) after retirement is tax-free. The amount that remains on the employee's credit on the day of termination of employment is tax-free, according to the Income-tax (IT) Act.

An employee of the Central Government may choose to convert up to 40% of their pension into a single lump sum payment. If the option is exercised within a year of retirement, there is no need for a medical check.

Disclaimer - This article is issued in the general public interest and meant for general information purposes only. The views expressed in this blog are solely those of the writer and do not necessarily reflect the official policy or position of Canara HSBC Life Insurance Company Limited or any affiliated entity. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability with respect to the blog or the information, products, services, or related graphics contained in the blog for any purpose. Any reliance you place on such information is therefore strictly at your own risk. You should consult with a qualified professional regarding your specific circumstances before taking any action based on the content provided herein.