Pension funds are one of the financial tools that assist an individual after retirement. It is a form of employee benefit under which regular contribution is made by the employer towards the pension fund of an employee. Investing in pension funds is very vital so that you have an adequate amount of funds to maintain your lifestyle and take care of medical emergencies and other foreseen expenses.
Over the years, you will build up a considerable amount by investing little by little in pension funds. It has two stages:
- Accumulation Stage: In this stage, a small percentage of your salary will go towards the pension funds on a regular basis, until you retire.
- Vesting Stage: In this stage, you reap the benefits of your investments. You will get a steady flow of income once you retire.
How does Pension Plan Work?
Pension funds work by investing a small amount of your salary towards pension funds so that you can get a steady flow of income post-retirement.
Types of Pension Funds available in India:
Usually, pension plans are based on different types of investment options, like mentioned below:
For conservative investors, pension plans are sponsored by insurers and investment is solely the debt.
Some pension plans invest both in equity and debt.
Under the National Pension Scheme, Pension funds invest 100% in government securities or 100% in debt securities or a maximum of 75% in equity.
There are different types of pension funds in India:
National Pension Scheme (NPS): National Pension Scheme was introduced by the Government of India in 2004 for those who wish to grow their pension amount. Through this scheme, your savings will be invested in debt and equity instruments according to your preferences. You can withdraw 60% of your funds at the time of your retirement and the rest 40% goes toward an annuity plan. However, you have to invest at least Rs 1000 until 60 years of age. The returns depend on the type of fund you choose.
Public Provident Fund (PPF): It is a long-term investment option with a tenure of 15 years. It offers the power of compounding especially towards the end of the term. You can invest a maximum of Rs 1.5 Lakhs as a one-time payment or over a period of twelve months. However, PPFs are eligible for tax deductions under section 80C of the Income Tax Act 1961. The interest rate of PPF is decided by the government for each financial quarter based on the performance of government securities as they are market independent.
Deferred Annuity: It’s an insurance contract that generates income for retirement. It has tax benefits where no tax is charged on money invested until you plan to withdraw it. It can be invested through one-time investment or making regular contributions.
- Immediate Annuity: Under this scheme, your pension begins immediately as soon as you deposit the money. It offers a range of annuity options that you can choose from. As per Income Tax Act 1961, the tax exemption is offered on the premium of immediate annuity plans. The nominee is entitled to money in case of the death of the policyholder.
- Guaranteed Period Annuity: This type of annuity is offered on basis of a period such as 5, 10 or 15 years.
- Life Annuity: Under this scheme, the retired individual is paid an annuity for their entire lifetime. In case, the policyholder dies, the spouse receives the pension amount.
- Annuity Certain: In this scheme, an Annuity is paid to a retired individual for a certain amount of years. An individual can pick their period and in case of death, the beneficiary receives the amount.
- Pension Funds: This scheme is managed by the Pension Fund Regulatory and Development Authority (PFRDA) of India, under which six companies act as fund managers. They offer high returns at the time of maturity.
- Pension Plans with and without cover: Under this scheme, you get full life insurance coverage, if you opt for a pension plan with cover, which means in case the insurer dies, family members are paid in lump sum amounts. Pension plans without cover, it doesn’t offer life cover, which means the nominee gets the corpus amount. Immediate Annuity plans are without cover whereas deferred annuity plans come with a cover.
What are Tax Implications on Pension Funds?
Pension income is taxable in India. You can receive your pension income in either of two ways:
- Commuted Pension: Through this, you can avail 40% of your pension amount in lump sum amount within one year of retirement without any medical examination. As this is paid in one go, it can be used for any immediate financial needs after retirement. Tax implication on commuted pension varies across jobs and industries.
- Uncommuted Pension: Uncommuted pension is paid over a period of time in regular installments. It acts as a regular source of income to meet daily expenses after retirement. This is fully taxable for all types of employees across all industries.
Advantages of Pension Funds:
- It allows investors to invest in government securities or equity and debt investment depending on their risk appetite. More the risk, the higher the returns.
- It serves as a long-term saving plan, where you can save as a lump sum or multiple small payments over time.
- You can choose how to get paid back in the future, either the entire amount or annuity payments or a deferred annuity plan that will earn interest over payouts.
- It helps to combat inflation as you can get 1/3rd of payment as a lump sum and the rest 2/3rd of it in form of steady cash flow.
- It can be helpful in case of emergencies and can cover long-term healthcare needs.
Disadvantages of Pension Funds
- Though it allows for tax deductions, the maximum allowed deduction on life insurance is limited to Rs 1.5 Lakhs under Income Tax Act 1961.
- An annuity is taxable once you receive it after retirement.
- To obtain higher returns after your retirement, it is better to opt for high-risk options as other risk options won’t be enough to beat inflation.
- It is best suited for the early investor, as it will reap higher returns as compared to those who invest late.