In Budget 2021, the Government has introduced a tax on interest on employee contribution to EPF over Rs 2.5 lacs in a financial year.
The Government rationale is that many HNIs are taking benefit of tax-free interest by contributing heavily to the employee provident fund (EPF) account. Read this Economic Times article for more details. The Government feels it is not right that the HNIs should receive the benefit of such tax-free interest.
There is quite a bit of confusion about what has changed and what hasn’t. In this post, let’s explore such aspects.
By the way, there are two ways in which you contribute to your EPF account.
- Own contribution (Employee contribution). Qualifies for tax benefit of up to Rs 1.5 lacs under Section 80C of the Income Tax Act.
- Employer contribution (your employer contributes to your EPF account). Also qualifies for tax benefit.
Now to what has not changed.
What has not changed?
#1 Your contribution to EPF (above Rs 1.5 lacs) comes from post-tax income (It always did!)
Any investment (your contribution) into EPF above Rs 1.5 lacs goes from your post-tax income. The tax benefit under Section 80C is capped at Rs. 1.5 lacs. Thus, any Section 80C investment/expense more than Rs 1.5 lacs comes from your post-tax income. Or to put it in a different way, the excess investment above Rs 1.5 lacs does not help you save tax.
- EPF is not the only Section 80C investment. There are other competing products too such as PPF, ELSS, insurance etc. The cap of Rs 1.5 lacs per financial year is for all such investments/expenses combined. So, if you put Rs 60,000 in ELSS every year, then only Rs 90K of your EPF contribution saves you tax. Or if you are investing Rs 2 lacs in EPF, then 50K of EPF and 60K of ELSS is not helping you save any tax.
- That investment above Rs 1.5 lacs comes from post-tax income does not make EPF a bad investment. Why? Firstly, because any other investment that you make will come from your post-tax income. Secondly, EPF gives you tax-free interest income and tax-free maturity proceeds and remains an excellent fixed income investment for retirement.
#2 Nothing changes for your contribution until March 31, 2021
The change in tax rule shall apply only from April 1, 2021.
Your contribution until March 31, 2021 (irrespective of the amount) shall continue to earn tax-free interest even after March 31, 2021 (until maturity).
#3 Employer contribution more than Rs 7.5 lacs comes from post-tax income. Interest on such excess portion taxable too.
This rule was changed last year (Budget 2020).
Earlier, the employer contribution to your EPF account came from pre-tax income i.e., you got tax-benefit if your employer contributed to your EPF account. And the interest income on such portion was also exempt from tax.
In Budget 2020, the Government capped this tax benefit.
If the employer contribution (cumulative) to your EPF, NPS or superannuation account exceeded Rs 7.5 lacs in a financial year, the excess portion will be added to your income and taxed at your slab rate.
In addition, the interest that you earn on such excess amount is taxable too.
Now to what has changed.
What has changed?
#4 The interest on your contribution above Rs 2.5 lacs shall be taxable.
If you contribute more than Rs 2.5 lacs per financial year, then the interest earned on this excess amount will be taxable.
Let us say you contribute Rs 35,000 per month to EPF account in FY2022. That makes it Rs 4.2 lacs in a financial year.
That is Rs 1.7 lacs extra.
The difference comes in how the interest is taxed.
- Earlier, the interest income on the entire Rs 4.2 lacs would have been exempt from tax if you continued to work.
- Now, the interest only on the first Rs 2.5 lacs will be exempt from tax. The interest on the excess Rs 1.7 lacs will be added to your income and taxed at the slab rate.
- Note that the interest won’t be taxed in just the first year. The interest on such excess will be taxed every year. Thus, the interest earned on this Rs 1.7 lacs will be taxed every year.
Point to Note
- This new rule applies only to your contribution (employee contribution).
- Includes both mandatory and voluntary (VPF) contribution.
- This new rule does not apply to employer contribution. Rules pertaining to employer contribution were changed last year (Budget 2020). Referred in Point #3.
- Note that your contribution above Rs 1.5 lacs (Refer to #1) always came from post-tax income. Hence, no change in this regard too.
- This rules only changes how the interest income on your EPF contribution exceeding Rs 2.5 lacs will be taxed.
- EPF and PPF are different products. Nothing changes about PPF taxation.
Will the interest on interest on the excess amount also be taxed?
Continuing with the above example, Rs 1.7 lacs was the excess amount of own contribution.
Assuming EPF fetches 8%, Rs 1.7 lacs * 8 % = Rs 13,400
Now, will the interest on this Rs 13,400 be taxed in the coming years?
While we should wait for clarity in this matter from the Income Tax Department, in my opinion, such interest on interest will also be taxed. Otherwise, the purpose behind the change will be defeated.
I copy commentary from the Finance Bill, 2021 about the proposal and proposed change in the Income Tax Act. Section 10 of the Income Tax Act contain clauses to exempt income from EPF.
Clause (11) of the said section provides for exemption with respect to any payment from a provident fund to which the Provident Funds Act, 1925 applies or from any other provident fund set up by the Central Government and notified by it in this behalf in the Official Gazette.
Clause (12) of the said section provides for exemption with respect to the accumulated balance due and becoming payable to an employee participating in a recognised provident fund, to the extent provided in rule 8 of Part A of the Fourth Schedule.
It is proposed to insert a proviso to such of the aforesaid clauses so as to provide that the provisions of these clauses shall not apply to the income by way of interest accrued during the previous year in the account of a person to the extent it relates to the amount or the aggregate of amounts of contribution made by that person exceeding two lakh and fifty thousand rupees in any previous year in that fund, on or after the 1st day of April, 2021 and computed in such manner as may be provided by rules.
Proviso to be added after Clause 11 and 12 of Section 10
“Provided that the provisions of this clause shall not apply to the income by way of interest accrued during the previous year in the account of a person to the extent it relates to the amount or the aggregate of amounts of contribution made by that person exceeding two lakh and fifty thousand rupees in any previous year in that fund, on or after the 1st day of April 2021 and computed in such manner as may be prescribed;”;
Since Rs 13,400 is related to the excess over Rs 2.5 lacs, the interest on Rs 13,400 shall be taxable too in the future.
Hence, you can think of your EPF balance being divided into 3 parts.
- Exempt employee contribution
- Taxable employee contribution (excess over Rs 2.5 lacs per year after April 1, 2021 to be kept in this account). Interest on such excess shall also be added back to this account.
- Employer contribution (guess this can be divided into two parts too. One for less than 7.5 lacs and one for the excess).
Disclaimer: Please understand the final mode of calculation shall be specified by the Central Bureau of Direct Taxes later and the how this will be effected. This is just my opinion and my understanding may be incorrect.
What should you do?
Firstly, not many would be affected because of this change in rule.
Rs 2.5 lacs per annum means monthly contribution of Rs 20,833. So, if you are contributing up to Rs 20,833 per month, you are not affected by this change.
Assuming you contribute 12% of your basic salary, your basic salary should be Rs 1.73 lacs per month to breach Rs 20,833 in monthly EPF contribution. Annual basic salary of Rs 20.83 lacs. Not a small amount.
Mathematically, it seems unlikely that a taxpayer in lower than 30% tax bracket will be affected by this rule (unless the investor is contributing heavily by way of VPF).
If EPF pays 8.5% p.a. (assumption), then the post-tax return shall be 5.95% p.a. on the excess amount. In current times of low interest rates, this does not look bad. Other safe fixed income products will find it difficult to provide such returns on a post-tax basis.
However, times will change. It is possible that other investments (say debt funds) may be able to provide higher post-tax returns than taxable EPF. At that time, you will not be able to take money of EPF then. Hence, this complicates the decision.
By the way, if you do not have a PPF account yet, open one. PPF continues to provide tax-free interest. If you are planning to contribute say 3.5 lacs to your EPF account (including VPF), you can put Rs 2.5 lacs in EPF and Rs 1 lac in PPF. PPF will likely offer returns than the taxable portion of EPF.
By the way, if you want to know what happens to your EPF account if you don’t contribute to it, read this excellent post from Sreekanth.