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Provident fund is a retirement savings plan that aims at providing financial security to the people for retirement. This scheme is managed by the Government of India. Under this scheme, both employee and employer contribute a certain amount of funds to the scheme.
At the time of retirement, the employee receives the assured lump sum amount, including the self and employer contribution with interest on both. The amount can be withdrawn or taken out only after the completion of the maturity period. This lump sum payment allows individuals to have a financial safety net as they retire from work and don't have a steady monthly income.
However, this amount is subjected to tax, which has been affecting the way people have been investing in provident funds. We will look in detail at how the tax on provident fund interest is affecting salaried professionals.
Types of provident funds
It is crucial to know the types of provident fund before knowing how the tax on the fund interest is affecting people. They divided into two categories:
1. Employee Provident Fund (EPF)
The Employee Provident Fund (EPF) is a saving scheme to secure the retirement goals of individuals. Under this scheme, both employees and employers have to contribute 12% of the basic salary, including dearness allowances, to the EPF account. An individual can also voluntarily choose to contribute more than 12%. In case of default payment of PF contribution, the employer is liable to pay the penalty at the given rate.
2. Public Provident Fund (PPF)
Public Provident Fund (PPF), a scheme backed by the Government of India that aims to encourage the habit of saving among salaried individuals. This scheme also has the benefits of tax savings. A PPF starts with a minimum deposit of Rs. 500, which can be maximized up to a maximum of Rs. 1.5 Lakh in a financial year.
Tax on provident fund interest
The budget 2021 introduced some changes to the prevailing provident fund interest; the budget capped tax-free interest on the amount earned by the employee on their contributions to the provident fund.
From 1st April 2021, those employees contributing more than 2.5 Lakh a year to the employee provident fund are required to pay tax on the interest earned on the amount earned above this limit.
For example, if any employee contributes 3 Lakh to the EPF in the financial year March 2022 then, the interest of Rs. 50 thousand will be taxed based on the employee's income tax slab.
This tax is not relevant to PPF as the maximum contribution of PPF per year is Rs. 1,50,000, but this clause will apply to government employees who are covered under GPF (Government Provident Fund). However, it is not clear just yet if the tax will apply to contributions to the CPF (Contributory Provident Fund).
Individuals at risk of breaching the cap
Some individuals are at risk of crossing the limit of 2.5 Lakh and thus, be subjected to the tax. The cap can be breached in two ways. The 12% contribution of the employee who is earning more than 20.8 Lakh a year in basic salary will breach the cap.
The other way the cap can be breached is if the employee chooses to voluntarily bolster the contributions to the EPF. Employees are allowed to increase their contributions to the provident fund through the Voluntary Provident Fund on the condition that the contribution should not be more than 100% of the basic salary.
Here is the impact of the cap on tax-free EPF returns:
|FY||Basic Salary||PF Contribution (12% of Basic + Employer’s Contribution)||Post Tax Interest (at the rate of 8%)|
Is there a way to avoid paying tax on the extra amount?
People who are voluntarily paying or contributing more to EPF have the option to invest the extra amount above Rs. 2.5 Lakh elsewhere if they want to be exempt from tax.
Apart from this, the new labor law or new wage code tends to make it much difficult for the people to revert from paying tax, as the law states that the basic salary must be at least 50% of total income, and if the basic salary is hiked, PF contributions will go up relatively as:
|Income Heads (Rs.)||Existing Structure||After New Wage Code|
|Total Per Month||2,30,000||2,30,000|
And the impact on the provident fund contribution will be as:
|PF contribution per year||1,20,960||1,65,600|
|Maximum VPF without Tax||1,29,040||84,400|
|Maximum VPF per Month||10,753||7,033|
As per the new labor law, the basic salary of an employee should be at least 50% of the cost to the company they are working in. If this 50% tends to surpass Rs. 20.8 Lakh a year, then the employee has only one option, and that is to cap basic salary at Rs. 15,000 per month for computing EPF contribution. Also, under this law, a compulsory deduction in the provident fund will be applied for those with a basic salary of up to Rs. 15,000.
But this option has a drawback too. Employers must match an employee's contribution to the EPF up to 12% of the basic salary, and in this case, when the employee tends to cap the basic salary, the employer's contribution will also be capped to 12% of the basic salary of Rs. 15,000. And the rest amount which would have gone into the EPF will be taxable salary.
Lower returns from provident fund
Those people who have higher salaries and contributed more than the mandatory 12% will ultimately earn lower returns on their provident fund. It is evident that the bigger the contribution to the fund, the lower its returns.
How tax cuts return
The higher contributions are subject to tax, and due to this tax, the returns decrease. Provident fund interest on contribution beyond 2.5 Lakh is taxed, assuming that the returns for PF and PPF are 8.5% and 7.1%, respectively; the following table shows how tax cuts the returns:
|Contribution to Provident Fund in a year||Overall Returns (%) From Provident Fund||If limit Includes Rs. 1.5 Lakh in PPF|
|Up to Rs. 2.5 Lakh||8.50||7.14|
|Rs. 3 Lakh||8.06||7.00|
|Rs. 4 Lakh||7.51||6.79|
|Rs. 5 Lakh||7.17||6.64|
|Rs. 6 Lakh||6.95||6.54|
|Rs. 9 Lakh||6.58||6.34|
|Rs. 12 Lakh||6.40||6.23|
|Rs. 15 Lakh||6.29||6.16|
|Rs. 18 Lakh||6.22||6.11|
|Rs. 24 Lakh||6.12||6.05|
Benefits of provident fund
It is also essential to know the benefits of the provident fund along with the tax on provident fund interest. This scheme provides many benefits apart from financial security; they are:
Under section 80C of the Income Tax Act 1961, the employee contribution towards the provident fund account is exempt from the tax. Additionally, the interest in the provident fund is also exempted from income tax. The employee can get a maximum of Rs. 1.5 Lakhs.
No tax liability is applicable if the employee makes a withdrawal from the provident fund account after the completion of 5 years of continuous employment, but if the employee withdraws before 5 years, then the amount will be taxable. Moreover, the employer's contribution and provident fund interest rate will be added to the employee's income and further taxed accordingly.
The employee and employer's contribution to the scheme ensures the lifelong pension for the employee. The lifelong pension is ensured even if the contributions are made for ten years.
The Employee Provident Fund Organization (EPFO) offers life insurance coverage under Employee Deposit Linked Insurance Scheme (EDLI). Under this scheme, the nominee receives the lump sum amount in case of the demise of the insured person during the period of service. Any employee holding an EPF (Employee Provident Fund) account is eligible for the scheme.
The Indian Government has simplified the rules of withdrawal from provident fund accounts to some great extent. The employee can make a premature withdrawal if he/she hasn't switched the job within two months from the date of resignation. Although, this restriction isn't applicable if the individual gets a job opportunity abroad.
The budget decision on the tax on provident fund interest based on the principle of equity among the contributors as the small group of High Net worth Individuals (HNIs) has been deriving the extra benefit of the interest rate on the large sums of money that too at the cost of the average account holder. The tax earned on the part of the provident fund contribution above Rs. 2.5 Lakh will be added to the total income of the taxpayer. This new clause will come into effect from 1st April 2021.