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Commuted Pension

A pension plan is an investment for the long run that will shield your financial future after retirement. A commuted pension lets you to receive a lump payment at once and the remaining amount in predetermined installments during your lifetime. Read this blog to learn more about the commuted pension scheme in detail.

 

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Commuted Pension

Guide on Commuted Pension Scheme

Commuted Pension Scheme
November 18, 2024

Table of Content

 

A pension plan is a long-term investment to secure your financial life after retirement. Being a responsible pension policyholder, there are two options for types of pension plans to opt for: either receiving the pension amount monthly or as a lump sum in advance. Prior financial planning is thus needed to determine the commuted value of a pension plan. This assists you in achieving your desired financial goals.

Continue reading this blog to know more about the commuted pension scheme in detail.

What Is a Commuted Pension?

During years of working, you invest a certain amount in the annuity fund to receive a stable income as a pension once you retire. To receive the accumulated amount after retirement, you can choose a monthly mode or advanced payment of a lump sum amount.

If you opt for a one-time lump-sum payout from a pension plan instead of getting smaller amounts in intervals, it is referred to as a commuted pension. In other words, a commuted pension allows you to receive a lump sum amount at a time and the remaining amount in fixed installments throughout your life.

Central Government employees can commute up to 40% of their pension as a lump sum payment without the need to undergo a medical examination before retirement. However, medical examination is required in case the commutation facility is availed after retirement.

How to Calculate Commuted Pension?

Commuted pension is easy to calculate using a pension calculator. The pension calculator considers personal details such as age, savings and investment, current income, daily expenses, and retirement age.

To calculate a commuted pension, here is the formula considered:

Commuted Value = 40% of P * CF *12

Where P = Pension Ordered

CF = Commutation Factor

Following this formula, we can calculate commuted pension considering the data given in the table below:

Age (next birthday) Commutation Value Expressed as Number of Year’s Purchase
20 19.01
21 18.91
22 18.81
23 18.70
24 18.59
25 18.47
26 18.34
27 18.21
28 18.07
29 17.93
30 17.78

Advantages of Commuted Pension

Availing the commutation facility might sound challenging and risky, but there are several advantages. Here is a detailed overview of the benefits of commuted pension.

  • Financial Flexibility

With pension commutation, you can achieve financial flexibility. A traditional pension provides you with a fixed monthly income in your retirement years. This allows you to possess control over your finances and stay independent financially.

  • Investment Opportunities

The commutation facility lets you invest a large sum of money in stocks, bonds and real estate. Thus, your overall return increases with the diversification of your investment portfolio.

  • Freedom of Choice

Pension commutation offers you the freedom of choice of using the lump sum amount received as a pension. Thus, you can access lump sum cash immediately. With the amount received, you can choose to start a new business, pay off debts or invest in large purchases without worrying about pension payments.

  • Elimination of Longevity Risk

Pension commutation allows you to maintain a decent standard of living with comprehensive insurance coverage throughout your life.

  • Estate Planning

Pension commutation is an important tool for estate planning. After receiving the lump sum amount as a pension, you can transfer it to your beneficiaries after death. Thus, it will provide financial assistance to your family in your absence. It will also be treated as a valuable, stable source of income.

Disadvantages of Commuted Pension

Retirees who want early access to pension funds will consider commuted pension advantageous. However, apart from the advantages, there are a few disadvantages of this pension withdrawal facility:

  • Risk of Mismanagement

Opting for the pension amount in a lump sum can be challenging to manage. Thus, there are some risks of mismanagement of funds. If you don’t have sufficient financial knowledge or you fail to make a proper financial plan, you might end up spending the fund amount quickly or reach a poor investment decision.

  • Loss of Guaranteed Income

Opting for a commuted pension results in a loss of your guaranteed2 monthly income. This is because you are exchanging future pension income with a lump sum payment. This might appear to be a good idea in the short term but it creates an adverse effect on your long-term financial security.

  • Tax Implications

This is another disadvantage of commuted pensions. The lump sum amount received as a pension is subjected to taxation, which implies that you are liable to pay a significant portion of the tax on the lump sum amount received. Moreover, if your age is 55 or below, you might have to face additional penalties on taxes.

  • Inflation Risk

Inflation risk is another risk factor associated with commuted pensions. Commuting pension implies locking a fixed amount of money, which is not responsive to changes in inflation. If you cannot grow your money, it will lose its purchasing value over time.

  • No Lifetime Protection

Traditional pensions provide retirees with a guaranteed2 income for a lifetime. This is, however, different for commuted pension. It offers no guaranteed2 income and, thus, no lifetime protection. Once you complete spending the lump sum amount, there will be no fixed monthly income. Thus, you may not have sufficient funds in your hand in later life during urgent situations.

Taxation on Commuted Pension

The tax on commuted pension differs from one person to another. Let us discuss it in detail:

  • Government Employee

The commuted pension that government employees receive is exempted from taxes.

  • Private Employee

Whether the commuted pension that private employees receive will be exempted from taxes depends on the gratuity received. This thereby gives rise to two scenarios:

a) An individual receives both pension and gratuity: If there is a 100% commuted pension, then one-third of the pension amount is exempted from taxes while the remaining half is subjected to taxation as salary.

b) An individual receives only a pension and not gratuity: If there is a 100% commuted pension, then 50% of the pension amount is exempted from taxes.

Factors to Consider Before Choosing a Commuted Pension

A commuted pension provides a lump sum payout instead of monthly instalments, which has a significant effect on your finances after retirement. Thus, gaining a proper understanding of your financial needs and goals is of utmost importance to assist you in reaching an informed decision aligning with your long-term objectives.

Here are the most important factors you should consider before selecting a commuted pension plan:

  • Modified Pension Income

    • Choosing to commute a significant portion of your accumulated corpus provides you with a lump sum payment that helps you meet your financial needs. This, however, impacts your future income. Thus, make sure that your financial goals and stability are minimally affected when you modify your pension income.

  • Financial Situation

    • Understanding your financial condition is the first and foremost step in determining whether commuting your pension is the right decision. Make sure to consider your present savings amount and other sources of retirement income before you make the decision. Additionally, consider your future and present needs to maintain a stress-free life after retirement.

  • Tax Implications

    • A certain portion of the commuted pension is subjected to taxation. Thus, make sure to check out the prevailing tax laws to gain a proper understanding of the impact of pension commutation on taxes.

  • Medical Expenses

    • Rising healthcare costs may negatively impact your existing retirement plans as it could deplete your savings. Thus, explore the rising costs of medicine and its impact on your monthly budget before commuting your pension to ensure adequate funds for meeting future expenses.

  • Risk of Outliving Your Savings

    • The risk of outliving your savings is another primary concern when opting for a commuted pension. With a commuted pension, you receive a lump sum amount and forego part of the monthly income that a traditional pension provides. This could significantly reduce your pension income.

    A large commutation amount may result in insufficient income over time due to market fluctuations and inflation. Thus, your savings may get exhausted, and you may suffer from financial instability post-retirement.

Do you Need to File an ITR for Commuted Pension?

Filing ITR is mandatory if the commuted amount received is higher than the tax-exempt amount. In this case, you need to pay the full tax amount on the extra commuted amount received. To avoid taxation for commuted pension, fill out Form 10E. The government imposes certain relaxations under Section 89 of the Income Tax Act1.

You can face financial emergencies anytime. A commuted pension serves the purpose during this urgent situation. However, because the commuted pension amount is subject to taxation, make sure to address the tax exemption limit before you opt for such options.

On the other hand, if you get an uncommuted pension, it is mandatory to file ITR 1 as the entire pension amount is taxable.

What Happens If You Receive a Pension as a Family Member?

If your family members receive a pension, the taxation rules will be somewhat different. In this scenario, your income will be subjected to taxation under 'Income from other sources' in the ITR of family members. 

Let’s delve deep to gain a proper understanding of what happens when your family member receives a pension:

  • If family members of armed forces employees receive the pension amount, it will be tax-exempted
  • If an employee's family member receives a certain amount of uncommuted pension, up to one-third of the pension amount received in any financial year will be exempt from taxes.

Getting Tax Exemptions on Commuted Pension

Retirees aiming for income maximization should consider the various tax exemptions applicable to their commuted pension income. A commuted pension is a lump sum amount you can withdraw from the accumulated corpus of an pension  plan. Thus, understanding its tax implications is very important. 

Income tax Implications on Commuted pension or lump sum pension is as below -

For Government Employees: Fully Exempt

For Non Government Employees:

1. Employee receives both Gratuity & Pension : The commuted value of  1/3rd of the pension amount the employee is entitled to receive is exempt & remaining is taxed as salary.

2. Employee does not receive Gratuity i.e. only pension is received :  The commuted value of ½ of the pension amount the employee is entitled to receive is exempt & remaining is taxed as salary

3. Any payment received in commutation of pension as a lump sum on vesting (maturity) from a Pension Plan of a life insurance company is completely exempt, subject to fulfilment of various conditions under the current income-tax law.

You can further minimize your tax burden and save more of your hard-earned income by opting for any of the given tax-saving investments:

  • Equity Linked Saving Scheme (ELSS)

    • Investing in Equity Linked Saving Scheme (ELSS) is an ideal option to yield higher returns. It has a lock-in period of 3 years, and the invested amount is subject to tax exemption of up to Rs. 1.5 Lakh under Section 80C of the Income Tax Act, 19611, subject to the overall Section 80CCE1 limit of ₹1.5 lakhs.

  • Fixed Deposits

    • A tax-saving fixed deposit has a lock-in period of 5 years and is eligible for tax deductions under section 80C of Incomce Tax Act, 19611, subject to the overall Section 80CCE1 limit of ₹1.5 lakhs. If you are 60 years and above, the bank provides you an additional rate of interest.

  • Unit Linked Insurance Plan (ULIP)

    • Unit Linked Insurance Plan (ULIP) offers you the dual benefits of insurance and investment. Here, the premium amount paid during any fiscal year is subject to tax deductions under Section 80C1, subject to the overall Section 80CCE1 limit of ₹1.5 lakhs. Furthermore, you can gain from tax exemptions on the maturity benefit, subject to certain conditions for policies issued on or after 01-02-2021:.

  • The premium paid is not in excess of 10% of the actual capital sum assured (i.e. death sum assured) throughout the policy term.
  • If the premium payable for any year during the term of policy does not exceeds Rs. 2.5 lakhs and
  • Aggregate annual premium should not exceed Rs. 2.5 lakh for all policies held by the policyholder with all life insurers for policies issued on or after February 1, 2021

Death benefits received by the nominee shall be completely tax free.

  • Pension Plan Investments

    • The pension plans available under certain life insurance companies qualify for tax deductions under Section 80CCC of the Income Tax Act 19611. Subject to the overall Section 80CCE limit of ₹1.5 lakhs.

  • National Savings Certificates (NSC)

    • National Savings Certificates is also another safe mode of investment that allows you to claim tax deductions under Section 80C of Income Tax Act, 19611, subject to the overall Section 80CCE limit of ₹1.5 lakhs. The interest earned, however, is subjected to taxation after five years or so. 

  • Senior Citizens Savings Scheme

    • By opting for a senior citizens savings scheme, you can convert your taxable commuted pension into a tax-free amount if you invest in such Scheme, such investments also qualify for tax deduction under Section 80C of the Income Tax Act1, subject to the overall Section 80CCE1 limit of ₹1.5 lakhs.

Conclusion

Commuted pension is ideal for retirees with financial goals, as they can opt for a lump sum payment in advance rather than monthly disbursements. This option is particularly beneficial for those needing urgent funds or looking to invest in diverse portfolios. When considering various pension plan comparisons, it's essential to incorporate financial planning to achieve retirement goals and maintain a decent standard of living.

FAQs on Commuted Pension

1. What is the meaning of commuted pension?

A commuted pension is the lump sum amount you receive from your pension plan rather than receiving it in small amounts regularly. Commuted pension thus provides you with a one-time payout on an immediate basis, allowing you to meet a financial crisis or fulfil a financial goal.

2. What is the difference between a commuted and uncommuted pension?

When you receive a lump sum amount from a pension plan, it is a commuted pension. On the other hand, when you receive the full pension amount without lump sum withdrawal, it is an uncommuted pension.

3. What is the commuted value of a pension?

The commuted value of a pension is when you withdraw a lump sum amount without affecting your future gains.

4. Which is better- commutation or full pension?

A commuted pension is better than a full pension because, with a commuted pension amount, you can meet your financial urgencies. However, if you prefer small but regular payouts, you can choose an uncommuted pension. Make sure to understand the tax implications before opting for either option.

5. How is the commutation amount of a pension calculated?

The formula for calculating the commutation amount of a pension is:

Commuted Value = 40% of Pension ordered * Commutation Factor *12

6. How much pension will I get after the commutation?

After commutation, you can expect to receive a certain portion of your pension, not more than 40% of the amount.

7. Is commutation of pension tax-free?

Whether the commutation of pension is tax-free depends on several factors, such as the type of pension and its source. However, the commuted part of the pension that a government employee receives is exempted from any tax. For private sector employees, a part of the commuted pension is exempt from taxes. 

8. Should I file an income tax return on my pension income?

Filing an income tax return is mandatory if your annual pension income is more than Rs. 2.5 lakh. The income limits is Rs. 3 lakh for citizens aged 60 and above. Whereas, for super senior citizens aged 80 and above, the limit is Rs. 5 lakh.

However Senior citizens are not required to file ITR if following conditions satisfied: - 

a) His is 75 year of age or more 

b) His income only from pension and interest (from same bank in which pension received)

c) His is Submit a declaration to the bank and TDS is deducted by the bank under Section 194P.

References

https://www.iciciprulife.com/retirement-pension-plans/commuted-pension.html#:~:text=Factors%20to%20consider%20before%20opting%20for%20a%20commuted%20pension

https://tax2win.in/guide/income-tax-for-pensioners

https://www.idfcfirstbank.com/finfirst-blogs/finance/commuted-pension-meaning-taxability-and-more

https://www.adityabirlacapital.com/abc-of-money/how-much-of-commuted-pension-is-exempt#:~:text=Government%20employees%20are%20entirely%20exempted,while%20the%20remainder%20is%20taxable.

https://www.canarahsbclife.com/blog/retirement-plan/commuted-value-of-pension#:~:text=What%20if%20you%20Receive%20a%20Pension%20as%20a%20Family%20Member%3F

https://cleartax.in/s/are-pensions-taxable

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Francis Rodrigues Francis Rodrigues

Francis Rodrigues has a decade long experience in the insurance sector, and as SVP, E-Commerce and Digital Marketing, HDFC Life, manages the online sales channel, as well as digital and performance marketing. He has had hands-on experience in setting up sales channels and functional teams from scratch over a career spanning 2 decades.

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