Should You contribute more than 2.5 lakhs to your PF after 1st April 21?

Contribution to Provident fund post April 2021...To Be or not To Be...?

The Provident Fund has always been a hot favourite with employees.  For many years now, given the tax benefits at the time of contribution, tax free interest and then tax free at the time of withdrawal(EEE), "The Provident Fund" enjoys almost a cult like status. It's an integral part of the family finances; familiar, stable, assured and something that is akin to mecca for investors!

Given the affinity to this investment instrument, it is not surprising that for many investors, it was a great setback when The Union Budget 2021 proposed taxing the interest on Provident Fund contributions of over Rs. 2.5 lakh a year.  As per clause 5 of the Finance bill 2021, the interest on ay contribution above Rs. 2.5 lakh by an employee to a recognized Provident fund will be taxable from 1st April 2021.

In the absence on clarity, confusion prevailed as many investors were left wondering what this was all about.  The questions flying hard and fast ranged from whether this was really a good idea and how will it impact an individual. Before sharing my thoughts on the impact, let's have a peek at why this change has been done.

Why the boat has been rocked?

Typically the Provident fund pays a higher interest rate on the deposits as compared to any other small saving scheme or fixed deposits that offer guaranteed returns.  Add to this the EEE benefit, and it makes a very attractive investment option for the employees who would prefer to contribute larger sums to the fund.  The Govt however, finds it difficult to sustain this high rate of interest on GPF(Provident fund for Govt employees).

Similar to what Govts across the world do, the Indian govt's endeavour has been to redirect a portion of the large corpuses sitting in Provident funds into the market circulation and has steadily raised the limit of exposure to equity markets.  The reason for this is simple.  One, more money in circulation means higher liquidity and high liquidity means higher potential for growth.  Second, PF contributions are long term and equity can give better inflation adjusted returns in long term.

Slow and steady steps have been taken in the past like allowing a higher amount of funds of EPFO to be invested into Exchange Traded funds (ETF's) based on Nifty 50, Sensex, Central Public Sector Enterprises(CPSEs) and Bharat 22 Indices.  EPFO does not however, invest in shares of private companies.

So it comes as no surprise that after the retirement funds, the Govt now wants the individuals too to take their contributions to other saving instruments.

So what does it mean for you as an Individual?

1. Yearly contributions to the PF up to Rs. 2.5 lakhs per annum(translating into Rs. 20,834/month) would continue to earn tax free interest as before and you will also be eligible to the rebate under section 80C up to Rs. 1.5 lakhs/annum.  However, any interest earned on contributions over and above the figure of 2.5 lakhs would be subject to tax.
2. This rule will apply to all contributions to PF account on or after April 2021. Interest earned on the previous balance before 1st April 2021 would continue to earn tax free interest as before.
3. There will be a deduction of TDS on the extra interest earned just like in case of Fixed deposits.  However more clarity on same is awaited.
4. The income accrued on extra interest would be taxed as income from other sources(just like in the case of FD interest).
5. The outgo of tax would be as per tax slab.

Let us understand this with a simple illustration.  Mr X contributes Rs. 3 lakhs to this PF account for the FY 2021-2022. His tax liability would be calculated in the following manner:

Employee contribution/annum                 3,00,000

ROI                                                                 7.1%

Tax free interest earned on 2.5 lakhs             17750/-

Taxable interest earned on balance                 3,550/-

TDS:                                                                355/-

Amount added to the taxable salary                3,195/-

Additional tax to be paid                                 997/-

To Be or not to Be

If you are someone who is in the highest tax slab and are investing towards creating a sizeable retirement corpus it may be a good idea to redirect your contribution of over 2.5 lakhs per annum to more lucrative investments like SIP of mutual funds.  You can enjoy the benefit of higher growth and lower tax outgo.

Tax saved is money saved and that much more in your pockets.  Hence from this angle a mixed contribution is better.  

However, if a higher tax outgo doesn't trouble you and you are the kind who is still comfortable with the Provident fund, then by all means go ahead the PF way.

Financial requirements, age and risk affinity of each individual is different. The investment pattern therefore also has to be different.

On a closing note, the question of 'To be or not To Be' is a choice that you as an investor have to make based on your individual requirements!

Cheers to an informed investor!

Anupama Bhargava CFP

Partner Beekay Taxation & Investment LLP