Under the Employees Provident Fund (EPF) scheme, an employer has to pay up to 12% of the basic monthly salary towards the fund and the employee has to make an equal contribution towards the fund. On retirement, the employee gets a lump sum amount along with interest for all the contributions made by both the employer and the employee.
Though the limit for contribution by the employer is 12% of the salary, the employee may make voluntary contributions under the scheme in excess of 12%. Till the year 2020-21, as per Section 10(11) of the Income Tax Act, 1961, the interest earned on the contributions made in the EPF scheme was tax-free.
However, in the Finance Bill, 2021, the Income Tax Act has been amended to impose a tax on interest earned on contributions made to a provident fund in excess of Rs 2.5 lakhs in a financial year.
According to Gaurav Choubey, Managing Partner, Choubey&Co, now any interest earned on contributions made by the employee below Rs 2.5 lakhs is tax-free, whereas any interest earned on contributions made above Rs 2.5 lakhs is taxable.
Tax calculation on EPF contribution by employee
The current interest rate for the EPF scheme is 8.5%. For example, if the total contribution to the EPF scheme by the employee in a financial year is Rs 4 lakh, the total interest earned in the financial year will be Rs 34,000. As per the new law, out of the total Rs 34,000, only a maximum of Rs 21,250 can be claimed as deductions in income, whereas the remaining Rs 12,750 will be counted as part of income for the income tax calculation.
It may be understood here that the maximum limit of deductions that can be claimed in a financial year will vary based on the change in the interest rate under the EPF Scheme, said Choubey.
Implications of raising tax-free EPF contribution limit to Rs 5 for some contributors
On March 23, 2021, while providing clarifications, Finance Minister Nirmala Sitharaman intimated a further amendment in the Finance Bill, thereby increasing the threshold of contributions from Rs 2.5 to Rs 5 lakhs per annum for provident funds where there is no contribution made by the employer. Effectively, this change is not going to benefits salaried persons.
“However, considering that in the EPF scheme the employer has to mandatorily make the contributions, this increase in the threshold to Rs 5 lakhs is not applicable to the EPF scheme,” said Gaurav Choubey.
Dr Suresh Surana founder, RSM India, said that such amendment is likely to have a positive impact from taxation perspective for the employees who are sole contributors to the Provident Fund.
“It is pertinent to note that not all the employers/ organization are required to contribute to the Provident Fund but only such employers who are mandatorily required to register under the Employees’ Provident Fund and Miscellaneous Act, 1952. As per the said EPF Act, employers employing 20 or more employees are mandatorily required to register and contribute 12% of the Basic wages + Dearness Allowance + Retaining allowance to the PF account and an equivalent amount would be contributed by the employee,” Dr Surana told FE Online.
Two Scenarios of tax on EPF contribution
According to the RSM India founder, the initial proposal in the Finance Bill 2021 would have placed the self-contributing employee at a disadvantageous position with respect to the threshold limit vis-à-vis an employee in respect of whom the employer is also contributing to such fund.
“In other words, the earlier proposed provisions specified the same threshold of Rs. 2,50,000 pa for cases where employees are solely contribution to the PF as well as where the employers and employees are both contributing to such funds. The amendment to the Finance Bill 2021 would have the effect of enhancing the threshold limit to Rs. 5,00,000 in case where the employee is the sole contributor to the Provident Fund. Thus, an employee would not be subject to tax on the interest derived from a PF to the extent it relates to amount of Provident Fund contribution upto Rs. 5,00,000/-. Only, where the contribution exceeds Rs. 5,00,000, tax would be levied on the interest amount exceeding such threshold.” said Dr Surana.
Plan your tax
Dr Surana said that in the new Financial Year (effective from April 1, 2021), taxpayers who are the sole contributors to the Provident Funds can review their tax planning in order to accommodate for contributions to such funds up to Rs. 500,000 or Rs. 250,000 (as the case may be) in order to avail optimum tax exemptions on interest derived from the provident Funds.
“Any interest on contributions exceeding Rs. 500,000 or Rs. 250,000 (as the case may be) would be subjected to tax. As such, the taxpayers before making such excess contribution towards PF should also evaluate the other instruments, wherein the rate of return is either comparative or higher so that they can make an informed decision before making such contributions,” he concluded.