The Union Budget 2021 has capped the tax exemption for interest earned on Employees Provident Fund (EPF) and Voluntary Provident Fund (VPF). This might not be welcome news for high-earners and more so for those whose (employee) contribution was more than Rs 2.5 lakh per year.
From April 2021 (FY2021-22) onwards, the interest earned on contributions above Rs 2.5 lakh per year by an employee to EPF & VPF will be taxable.
Do note that this change will be applicable only to contributions made on or after 1st April 2021 and is not applicable retrospectively. Also, this will only apply to the employee’s contribution to PF and not that of the employer.
So now, if your contribution to the provident fund, be it via statutory EPF deductions or voluntary VPF contributions, exceeds Rs 2.5 lakh per year, then the interest earned on the excess contribution (above Rs 2.5 lakh) will be taxable. One more thing. The tax would apply only on the interest earned on the excess contribution and not the contribution itself.
For example, if you are an employee who contributes to both EPF and VPF to the tune of Rs 2.4 lakh (via EPF monthly Rs 20,000) and Rs 3.6 lakh (Rs 30,000 per month via VPF), then the total employee contribution to PF for you is Rs 6 lakh. As per the new rule, the amount for tax-free interest status is Rs 2.5 lakh. That means that the from FY 2021-22 onwards, the interest earned on excess Rs 3.5 lakh (= Rs 6 lakh – Rs 2.5 lakh) will be taxable.
Till FY 2020-21, all interest income earned on employee contributions to EPF were completely tax free. But from FY2021-22, interest on employee contributions above Rs 2.5 lakh a year will be taxable.
Till now, EPF & VPF contribution enjoyed a very favourable tax treatment and any interest accrued was tax-free regardless of how large the contributions were. This and being sovereign backed debt tool had made EPF a useful too for retirement planning.
Too early to say but seemingly, this will hit the high-income salaried individuals who use to max up their VPF contributions. And rightly so. Where else could you find a tax-free, risk-free debt product giving reasonable returns (check historical VPF interest rates). Its possible that some high-earners might look at moving towards NPS due to this change (inspite of few shortcomings of the pension tool).
Why was this rule change brought about?
To be sure is not possible but seemingly, the idea was to put a cap on tax benefits availed by high-income earners who made large contributions to their EPF (and VPF) account. This was a sort of loophole for highly paid employees to enjoy tax-free interest that the government wanted to plug.
By the way, this is not the first time that the government has proposed to tax EPF money. In Budget 2016, it was proposed that the interest accrued on 60% of the EPF would be taxed. But the proposal met with a lot of hue and cry and had to be rolled back. So maybe, the government is taking smaller steps now to tax the EPF money eventually. Who knows!
So with now the interest on employee contribution to EPF above ₹2.5 lakh a year being taxable, it will be interesting to see how the impacted employees change their savings habit going forward.