Income earned from Provident Fund (PF) contributions might become taxable for you. In the recent Budget, the Finance Minister announced that the interest earned on employee contribution towards PF exceeding Rs 2.5 lakh in a year would be taxable from the 1st of April 2021. In the past, many opted for Voluntary Provident Funds (VPF) so that they could contribute more towards PF and avail of its tax-free benefits.
Should you look beyond VPF while creating an investment portfolio?
First of all, let’s understand VPF?
VPF is an extension of your Employee Provident Fund (EPF) which is available to all salaried individuals. Under the EPF set-up, the employee, as well as the employer, compulsorily contributes 12% each of the basic salary towards EPF account of the employee. Any contributions made by the employee beyond such threshold becomes voluntary and hence the name. As per the rules, an employee can contribute up to 100% of one’s basic salary (including dearness allowance) in a financial year as part of VPF contributions. However, the employer is not under any obligation to match his contribution.
High coupon rate
VPF is linked to your existing EPF and interest rates on its contributions are the same as that of EPF. For the financial year 2019-20, its interest rate was 8.5% p.a and is announced every year by the EPFO. VPF contributions have been popular among people due to its relatively higher interest rate as compared to Public Provident Fund (7.1% p.a) and other small saving schemes. Contributions made towards PF (including VPF) are also allowed as a deduction from income under Sec 80 C of the Income tax Act.
How does it work?
Supposing you earn an income of Rs 1 lakh a month, out of which 40% comprises the basic salary component. Under the usual set-up, your employer contributes 12% of your basic salary or Rs 4,800 (12% of Rs 40,000) towards EPF, while another 12% is contributed on your behalf.
If you opted for VPF and contributed another 50% of basic salary – then your overall PF contribution per month would be 62% of basic salary. It works out to Rs 24,800 a month or Rs 2,97,600 in a year. While earlier, interest earned on these incremental contributions were completely tax-free, from April 1st – excess contributions over Rs 2.5 lakh will be taxed at your marginal rate. Remember, an employer’s contribution towards EPF is not considered for taxation purposes.
In the above case, any VPF contributions above 40% attract taxes. It could differ based on one’s salary and its component of basic salary.
* 30% tax bracket
** Applicable from 1st April 2021
Interest rates on EPF funds have been falling down over the years and are currently at a seven-year low. From a high of 8.8% p.a. in 2015-16, interest rates have come down to 8.5% in 2019-20. EPFO, which manages employee provident funds, typically invest 85% of their annual inflows into debt instruments, while the rest goes into equities (exchange-traded funds). Ultimately, rates decided by EPFO trustees have to be in sync with market rates.
An individual in their 30s and 40s are better-off taking larger exposure in equities (than above) – which could earn 11% or more annually on their investments. While the income earned on PF would soon lose its tax-free status, it will also lose its luster once the Direct Tax Code (DTC) comes into effect. Under the DTC provisions, the entire maturity amount is set to become taxable.
Moreover, there is the looming provision of the New-Wage Code. From April 1 of this year, the basic salary component is mandated to be at least 50% of your overall salary. This in turn could increase your annual EPF contributions as well as tax liabilities. While it is currently applicable only for low-income people (Rs 15,000 or lesser), it could have greater repercussions if this income threshold is done away with under the Social Security Code.
How to withdraw
VPF contributions don’t require any separate registration. Usually, the employee intimates her HR or accounts department in writing about it by specifying the amount she wants to invest for the year. Once you do it, you can’t change it midway during the year.
If you want to opt-out of VPF, intimate your HR or accounts department in writing before the start of the financial year. There is a lock-in period of five years, during which a penalty is applicable for premature withdrawal. After that, you can withdraw the whole amount.
Taxation on interest earned from VPF contributions has taken the zing out of the investment product. Moreover, with DTC looming large, its time investors start looking beyond assured return schemes and into market-linked products like mutual funds.