Tax rules for NPS Tier 2 withdrawals before and after July 23, 2024

Tax rules for NPS withdrawal from Tier 2

Unlike National Pension System (NPS) Tier 1, where taxation at the time of withdrawal is clearly defined, the tax treatment of Tier 2 withdrawals is not separately prescribed in law. These withdrawals are taxed under general capital gains provisions, which makes their treatment less straightforward. So, the question is whether investments in NPS Tier 2 accounts qualify as long-term capital assets, and if so, whether indexation benefits apply, especially after the July 23, 2024 changes that withdrew the benefit on most assets. Today's Ask Wallet Wise query decodes tax rules on Tier 2 of NPS 

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Along with investing in Tier 1 NPS account, I also opened an NPS Tier 2 account and invested Rs 1 lakh on April 1, 2022. Due to a medical emergency, I had to redeem the full balance in my NPS Tier 2 account on June 15, 2024. I want to know if I can claim the indexation benefit on long-term capital gains (for units held for more than 24 months but less than 36 months) and pay tax at 20 percent.

Expert Advice: NPS Tier 2 is part of the National Pension System (NPS). The contribution made towards NPS Tier 1 qualifies for tax benefits under the old tax regime. Contributions made by the employer qualify for deduction under section 80CCD(2) in both the old and new tax regimes. However, no tax benefit is available on contributions to the Tier 2 account except for central government employees, where a three-year lock-in period applies.

Money withdrawn from a Tier 1 account after completing 60 years can be withdrawn tax-free up to 60 percent of the corpus. The balance 40 percent must be used to buy an annuity from a life insurance company in India. Unlike Tier 1, there are no specific provisions governing taxation of money withdrawn from the Tier 2 account. Therefore, withdrawals from Tier 2 are governed by the general provisions of capital gains taxation.

When you contribute to the NPS, you are allotted units based on the NAV on the date of contribution. However, these cannot be treated as equity-oriented mutual funds since pension fund managers are not recognised as mutual funds. Therefore, the general rule of a 36-month holding period to qualify as a long-term capital asset applies.

Similarly, Tier 2 investments cannot be treated as debt funds for the same reason. Therefore, redemption of Tier 2 units, irrespective of the holding period, cannot be taxed as short-term capital gains applicable to mutual funds.

Investments in the NPS Tier 2 account would be treated like any other capital asset. They become long-term capital assets only on completion of 36 months from the date of investment, if redeemed prior to July 23, 2024. Had they been redeemed on or after July 23, 2024, the holding period requirement would have reduced to 24 months.

The indexation benefit has been removed for all capital assets sold/transferred on or after July 23, 2024 except for the limited purpose of taxing sales of land and buildings acquired before that date by resident individuals and HUFs. Since you redeemed your NPS Tier 2 units before July 23, indexation benefit was still available. However, because the holding period requirement for Tier 2 units was 36 months, which you did not meet, the gains will be treated as short-term capital gains and taxed at slab rates.

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.