For the first time, the government has proposed to tax the employees’ provident fund (EPF), albeit only the interest income on contributions exceeding Rs 2.5 lakh in a year. In the recent Budget proposals, the government has proposed that tax exemption will not be available on interest income for the year on all contributions to provident funds exceeding Rs 2.5 lakh. While this may cause concern to all salaried individuals contributing to EPF, it will in fact impact only those who contribute more than Rs 2.5 lakh in a year — and it will not affect their existing corpus or the aggregate annual interest on that.
The Budget proposal noted that the government has found instances where some employees are contributing huge amounts to these funds and are getting the benefit of tax exemption at all stages — contribution, interest accumulation and withdrawal. With an aim to exclude high net-worth individuals (HNIs) from the benefit of high tax-free interest income on their large contributions, the government has proposed to impose a threshold limit of contributions at Rs 2.5 lakh for tax exemption. In other words, the interest income on all contributions above Rs 2.5 lakh a year will be taxable. This will be applicable for all contributions beginning April 1, 2021.
“This fund is actually for the benefit of the workers, and workers are not going to be affected by it,” Finance Minister Nirmala Sitharaman said. “… it is only for big-ticket money which comes into it because it has tax benefits and also (is) assured about 8% return. You find huge amounts, some to the extent of Rs 1 crore also being put into this each month. For somebody who puts Rs 1 crore into this fund each month, what should be his salary? So, for him to give both tax concessions and also an assured 8% return, we thought this is probably not comparable with an employee with about Rs 2 lakh.”
The annual contribution to EPF and Gratuity — and also voluntary contributions to EPF — will be added. If the aggregate contribution exceeds Rs 2.5 lakh, the interest income on that will be taxed at the marginal tax rate in which the income of the individual falls.
Importantly, only the contribution linked to employees’ component will be calculated for taxation purposes. The employer’s contribution towards the EPF will not be considered for the calculation.
For an individual in the higher tax bracket of 30%, the interest income on contribution above Rs 2.5 lakh would get taxed at the same marginal tax rate. What this means is that if an individual contributes Rs 3 lakh every year to the provident fund (including the voluntary PF contribution) then the interest on his contribution above Rs 2.5 lakh —that is, Rs 50,000 — will be taxed. So, the interest income of Rs 4,250 (8.5% on Rs 50,000) will be taxed at the marginal rate. If the individual falls in the highest tax bracket of 30%, he will have to pay tax of Rs 1,325.
For an individual contributing Rs 12 lakh in a year, the tax will be applicable on interest income on Rs 9.5 lakh (Rs 12 lakh minus Rs 2.5 lakh). In this case the tax liability would amount to Rs 25,200.
Financial planners say that will be the case: The interest income on the additional contribution of a year will get taxed every year. This means that if your annual contribution to PF in FY22 is Rs 10 lakh, the interest income on Rs 7.5 lakh will get taxed not only for FY22 but also for all subsequent years. If the PF contribution is the same for FY23, the tax will have be paid on interest income on Rs 15 lakh. Also, if you earned interest of 8.5% last year, and if you fall in the highest tax bracket, then the following year you will earn effectively around 5.85% on the additional contribution (assuming the interest rate is unchanged).
Investors who are not comfortable with debt or equity mutual funds and are willing to pay tax at marginal tax rate on the interest income (on additional contribution) could still go for voluntary contribution in provident fund. Those comfortable with mutual fund investments, on the other hand, can go for AAA-rated debt schemes or diversified large-cap funds for more tax efficient long-term gains. While long-term capital gains tax (after 12 months) for equity schemes is 10% for gains above Rs 1 lakh, the long-term tax on debt funds is 20% with indexation benefit. So, for tax efficiency and better returns, it is advisable to stop the voluntary contribution to PF as the interest income will get taxed at marginal tax rate if the contribution exceeds the threshold.
Also, since interest rates are in decline, many feel that going forward, the government may reduce the interest offering on EPF and so your corpus may fetch lower returns. While tax-free interest of 8.5% is the best one can get, once it starts getting taxed at 30%, the post-tax returns fall sharply to 5.85%. And if the rates were to fall to 8%, the returns would drop to 5.5%.
Any individual contributing more than Rs 20,833 per month will get impacted as her own contribution will be higher than Rs 2.5 lakh. All individuals with a monthly basic salary of over Rs 1,73,608 will have PF contributions in excess of Rs 2.5 lakh in a year, and hence they will pay tax on interest earned on that excess amount.
In the case of individuals whose basic salary is lower than Rs 173,608 per month but contribute voluntary PF, the move will affect them only if their aggregate contribution is beyond Rs 2.5 lakh. For example, if an individual has a basic salary of Rs 1.5 lakh per month, he would contribute Rs 216,000 as his own contribution to PF. However, if he pays an additional Rs 60,000 per year as voluntary contribution towards PF, he will find Rs 26,000 of his interest income getting taxed.
The government proposal clearly states that the tax will be on the interest income on the contribution exceeding Rs 2.5 lakh in a previous year. This means that the aggregate corpus (until March 31, 2021) and the interest income on that will not get impacted. The tax will be limited to contributions in excess of Rs 2.5 lakh beginning April 1, 2021.
According to sources in the know, out of over 4.5 crore contributors’ accounts to EPF, more than 1.23 lakh accounts belonging to HNIs contribute large sums to their EPF accounts every month. According to estimates, the total contribution of these HNI accounts for FY 2018-19 was Rs 62,500 crore (which comes to an average of Rs 50.8 lakh per contributor). A source added that the decision to remove the tax exemption on PF contributions above the threshold was based on the principle of equity among contributors.