Taxation of Retirement Benefits in Pakistan

Retirement benefits are crucial for financial security after a person completes their employment tenure. In Pakistan, retirement-related income such as pensions, gratuity, provident fund withdrawals, and other terminal benefits are either exempt, partially exempt, or fully taxable depending on the nature of employment (government or private) and compliance with certain tax rules. This article explores the taxation rules applicable to all major retirement benefits, including legal provisions, exemptions, limits, filing obligations, and planning opportunities.

Legal Framework Governing Retirement Benefits
The taxation of retirement benefits in Pakistan is governed by the Income Tax Ordinance, 2001, particularly under:

• Section 12 (Income under the head “Salary”)

• Section 39 (Income from Other Sources)

• Second Schedule of the Ordinance (for exemptions and conditions)

• Part III of the Income Tax Rules, 2002

Different types of retirement benefits are taxed differently based on whether the benefit is from a government, approved private scheme, or unapproved employer fund.

Types of Retirement Benefits in Pakistan
Retirement benefits in Pakistan generally include the following:

• Pension

• Gratuity

• Provident Fund (Recognized or Unrecognized)

• Approved Superannuation Funds

• Leave Encashment

• Commutation of Pension

• Benevolent Fund

• Group Insurance or Death Compensation

Each benefit is taxed differently, and exemptions vary depending on conditions set under the law.

Taxation of Pension Income
Pension received by a retired employee is treated differently for tax purposes:

Government Pensioners:

• Pension is fully exempt under Clause 75, Part I, Second Schedule of the Income Tax Ordinance, 2001.

Private Sector Pensioners:

• Commuted portion of pension is exempt up to 50% if received from an approved pension fund (Clause 13(vi), Part I, Second Schedule)

• Monthly uncommuted pension is generally treated as exempt if from an approved pension scheme

• Any amount exceeding approved limits may be taxed under Income from Other Sources

Commutation of Pension:

• Government employee: 100% tax-exempt

• Private employee: Up to 50% exempt if drawn from an approved pension fund; balance is taxable

Taxation of Gratuity
Gratuity is a lump sum payment made upon retirement, resignation, or death. Its tax treatment depends on whether it is paid under an approved or unapproved gratuity fund.

Government employees:

• Gratuity is fully exempt under Clause 13(i), Part I, Second Schedule

Private sector employees:

• If gratuity is paid from an approved gratuity fund: fully or partially exempt based on limits

• If paid from an unapproved fund: subject to tax after allowable deductions

• Maximum exemption limit for private employees is Rs. 300,000 (as per Rule 4 of Part III, Income Tax Rules)

Taxation of Provident Fund Withdrawals
Provident fund taxation depends on whether the fund is recognized or unrecognized:

Recognized Provident Fund (RPF):

• Employer’s contribution up to 10% of salary is exempt

• Interest up to 10% per annum is exempt

• Final withdrawal is exempt if:

  • Employee has served for 5 years or more

  • Termination is due to death, ill-health, or company closure

Unrecognized Provident Fund (URPF):

• Employer’s contribution and interest earned are fully taxable on withdrawal under Income from Salary

Approved Superannuation Fund
These are retirement savings schemes approved by the Commissioner of Inland Revenue. Payments from these funds are treated as follows:

• Commuted pension or lump sum: Partially exempt, up to Rs. 200,000 per year of service, subject to rules

• Uncommuted monthly pensions: Generally exempt, similar to approved pension fund rules

Leave Encashment at Retirement
Leave encashment received by an employee at retirement is taxed as follows:

Government employees:

• Fully exempt under Clause 13(iii), Part I, Second Schedule

Private employees:

• Exempt up to the amount that would have been received under government rules (Rule 5, Part III, Income Tax Rules)

• Balance amount is taxed under Salary

Benevolent Fund and Group Insurance
Amounts received from benevolent funds or as death compensation are:

• Fully exempt for dependents or legal heirs under Clause 56, Part I, Second Schedule

• Group insurance proceeds on employee’s death are also fully exempt

• If received on retirement or maturity (not death), may be partially taxable

Voluntary Pension System (VPS) Withdrawals
Contributions to VPS are eligible for tax credits. Upon retirement:

• Lump sum withdrawal up to 50% is exempt

• Remaining amount must be used to purchase an annuity or pension plan

• If withdrawn before maturity (before 60 years), taxable as salary

Tax Implications for Non-Resident Pakistanis (NRPs)
NRPs are taxed only on Pakistan-source income, so any pension or retirement benefit received from a Pakistani employer is taxable if:

• Paid in Pakistan

• Paid by a Pakistani resident employer

However, foreign pensions or benefits from abroad are not taxable in Pakistan for NRPs.

Double Taxation Relief on Foreign Retirement Benefits
If retirement benefits are earned abroad and taxed in that country, residents of Pakistan may claim relief under:

• Section 103 (Unilateral Relief)

• Double Taxation Treaties (if available with the source country)

Filing requirements and proof of foreign tax paid are necessary to claim credit.

Filing Requirements for Retired Individuals
Retired persons receiving only pension income from government sources may not need to file a tax return.

However, return filing is mandatory if the individual:

• Receives taxable gratuity, provident fund, or other retirement benefits

• Earns rental income, profit on debt, or income from investments

• Holds assets beyond the threshold for filing a wealth statement

Tax Planning Strategies for Retirement Benefits
To reduce tax burden, individuals should:

• Opt for approved funds where possible

• Serve for at least 5 years to get tax exemption on provident fund withdrawals

• Utilize Voluntary Pension Schemes (VPS) and claim tax credits

• Keep complete documentation of employer approvals, fund certifications, and payment proofs

FAQs on Retirement Benefits Taxation

Q. Is pension income always exempt?
A. Government pension is always exempt. Private pension is exempt if received from an approved fund and up to defined limits.

Q. How much gratuity is tax-free?
A. For government employees – fully exempt. For private employees – up to Rs. 300,000 if paid under approved fund and subject to service conditions.

Q. Are provident fund withdrawals taxed?
A. Recognized fund withdrawals after 5 years are exempt. Unrecognized fund withdrawals are taxable.

Q. Is group insurance taxable?
A. No, if received on death. If received on maturity or retirement, it may be taxable depending on the scheme.

Q. Can NRPs claim tax exemption on foreign pensions?
A. Yes. If they are non-residents under tax law, their foreign pension income is not taxable in Pakistan.

Q. Is VPS withdrawal before retirement taxable?
A. Yes. Premature withdrawal from a VPS is treated as salary and taxed accordingly.

Q. What is the benefit of having an approved gratuity fund?
A. Payments from an approved gratuity fund enjoy greater exemptions and lower tax liability than unapproved ones.

Key Clauses and Rules Summary

Conclusion
Retirement benefits are a critical financial resource for employees after their service ends. Pakistan’s tax law provides various exemptions and reliefs on pensions, gratuities, provident fund withdrawals, and other terminal benefits. Employees should understand which funds are approved, serve the qualifying period, and claim applicable tax credits. Employers must also ensure their retirement schemes are properly structured to provide maximum post-retirement tax relief to their employees