Tax Reforms

Taxing interest on Provident Fund

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Provident Fund

Mains level : Need for taxing PF

Following its Budget announcement in February, the Finance Ministry has now notified the rules for taxing interest income on contributions made to the Employees’ Provident Fund (EPF) beyond Rs 2.5 lakh (for private-sector employees) and Rs 5 lakh (for government sector employees).

What is Provident Fund?

  • Provident Fund is a government-managed retirement savings scheme for employees, who can contribute a part of their savings towards their pension fund, every month.
  • These monthly savings get accumulated every month and can be accessed as a lump sum amount at the time of retirement, or end of employment.
  • Since the provident fund money consists of a large chunk of savings, it can be used to grow your retirement corpus easily.

Types of provident funds

There are mainly three different types of PFs, which are as follows:

  1. General provident fund: It is a type of PF which is maintained by governmental bodies, including local authorities, the Railways, and other such bodies. Thus, these types of PFs are mainly defined by government bodies.
  2. Recognized provident fund: It is the one that applies to all privately-owned organizations that contain more than 20 employees. Moreover, holding a rightful claim to the PF associated with your organization, you will be given a UAN or Universal Account Number. This enables you to transfer your PF funds from one employer to another whenever you move from one occupation to another.
  3. Public provident fund: It is defined by the voluntary nature of investment on the part of the employee. The PPF is also associated with a minimum deposit of Rs. 50 and a maximum amount of Rs. 1.5 lakhs. The PPF has a lock-in period of 15 years.

What is the tax on EPF contributions?

  • In February, the Budget proposed that tax exemption will not be available on interest income on PF contributions exceeding Rs 2.5 lakh in a year.
  • Although this has been a concern for salaried individuals contributing to EPF, it will impact only those who contribute more than Rs 2.5 lakh in a year.
  • It will not affect their existing corpus or the aggregate annual interest on that.
  • In March, the government proposed to double the cap on contribution from Rs 2.5 lakh to Rs 5 lakh for tax-exempt interest income where there is no contribution by the employer.
  • With this, the government provided relief for contributions made to the General Provident Fund that is available only to government employees and there is no contribution by the employer.

Why tax the PF?

  • There have been 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 for tax exemption.
  • This will be applicable for all contributions beginning April 1, 2021.

How will it get taxed?

  • 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 30% tax bracket, he/ she will have to pay a 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.

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