Budget 2021: Provident Funds and Income tax

This Budget has brought major changes in the taxability of employee’s contribution to the provident fund which was hitherto untouched. The last year’s budget had introduced the limit of ₹750,000/- on the employer’s contribution (tax-free) to the NPS, EPF, and approved superannuation funds. This Budget has shifted the focus to the taxation of interest income from such funds. With this proposal in the Budget, the reputation of tax-efficient investments enjoyed by provident fund investments may start to wane.

What are the Provident Funds?
Broadly, there are two types of provident funds. Employee Provident Fund (EPF) and Public Provident Fund (PPF). EPF is meant for salaried employees where both the employer and employee contribute their contributions. The employee and employer each contribute 12% of basic salary plus DA to the EPF. The employer’s contribution after this mandatory 12% is taxed as a prerequisite in the hands of the employee. Additionally, there is a cap of ₹7,50,000/- on the contribution by the employer. The accumulated corpus with interest thereon is paid to an employee on his retirement or he can withdraw the same before retirement too as per rules. All the provident funds are discussed in detail here.

The PPF is a general provident fund available to all individuals and the contributions are eligible for deduction u/s 80C and maturity proceeds including interest are also tax-free. The scheme of investment into PPF is discussed in detail here.

How are the employee’s contributions to EPF are taxed now?
The employee’s contribution to PF is deductible u/s 80C of the Income-tax Act up to a maximum limit of ₹150,000/-. Thus, there is no tax on investment/deposits. The amounts deposited in PF earn interest currently at the rate of 8.5% and such interest income is tax-free. The withdrawal of the amounts from PF is also not taxable. Hence, the investments in PF follow the Exempt – Exempt – Exempt (EEE) formula. It is not taxed at any stage.

What is proposed in the Budget?
The Budget-2021 has attacked the middle E of E – E – E trinity. It sought to tax the interest income earned on the employee contributions of the amount of more than ₹2,50,000/-. This means the interest earned on the contributions which are more than ₹2,50,000/- will be subjected to tax. The interest earned on the contribution upto ₹2,50,000/- shall not be taxed. Thus, the new formula for PF contributions of more than ₹ 2,50,000/- shall be E – T – E. This law will be coming into effect from the financial year 2021-22 and assessment year 2022-23.

Illustration:
Shri Sunil earns ₹ 40,00,000/- in basic salary and DA. He contributes 12% of this amount to the EPF. The position of his PF account funds for F Y 2020-21 and 2021-22 will be as follows.

FY



(I)

Sunil’s entire contribution
(on ₹40L)

(II)

Maximum tax-free amount

(III)

Excess amount contributed

(IV)

Interest @ 8.5% on (IV)

(V)

Less tax @30% (excluding cess)

(VI)

Net accumulated corpus (excluding interest on 2.5L) *

(VII)

2020-21 4,80,000 2,50,000 2,30,000 19,550 0 4,99,550
2021-22 4,80,000 2,50,000 2,30,000 19,550 5,865 4,93,685

In the above table, the difference sounds less but it becomes quite substantial over the years because of the compounding effect.

How will this impact tax on salaried taxpayers?
This will not impact a large number of salaried taxpayers whose annual contribution to PF is ₹ 2,50,000/- or lesser. However, those salaried taxpayers who used to deposit heavy amounts in PF and earn triple tax benefits will be impacted. Now they will be made to pay tax on the interest income earned by them on PF contributions above ₹2,50,000/-.

How much will be the tax outgo?
The interest income will be taxed as income from other sources and shall be taxed at prevalent rates of tax. The TDS will be done by EPFO on the accrued amount of interest every year as of 31st March. The rate of TDS shall be 10% of the interest income. This TDS, you can claim a tax credit in your ITR.