Provident fund contribution is a statutory contribution for individuals who are employed whether in the government sector or the private sector. The most important thing about your provident fund is that, apart from being a source of forced savings for your future, it also is extremely efficient. In fact, if the tax benefits of a PF are factored in, then the effective yield is actually quite high. But one needs to understand the various facets of a provident fund in terms of contributions to the PF, interest earned on the PF and PF withdrawals along with the tax implication of each of them.
There are a variety of classifications in a provident fund. There is a PPF (public provident fund), which is open to any citizen of India and also proffers the tax benefits. Then there is the unrecognized provident fund which does not proffer many of the typical tax benefits of a provident fund. Lastly, our focus will be on the Contributory Recognized Provident Fund (EPF), which is one of the common ways most people save on a regular basis. Typically, these PFs are contributory where both the employer and employee contribute to the PF in equal measure. The EPFO (Employee Provident Funds Office) today manages close to Rs.650,000 crore ($100 billion) in assets under management.
Contributing to a Provident Fund…
Contribution to a provident fund is typically done by the employee at the rate of 12% of salary and this is matched by the employer. The contribution by the employer to your PF is actually a perk which is entirely tax free in the hands of the employer. Remember, only if the employer contributes up to 12% of salary, it is exempt in the hands of the employee; anything beyond is taxed as income in the hands of the employee. Similarly, the employee’s contribution to Provident Fund is exempt under Section 80C of the Income Tax Act. This has an outer limit of Rs.150,000 per annum and also encompasses other asset contributions like life insurance, infrastructure bonds, housing loan principal, long term FDs etc.. Here, only the employee’s contribution up to 12% of salary will be considered as eligible for Section 80C. Irrespective of what you contribute, your overall limit under Section 80C will be circumscribed by the outer limit of Rs.150,000 per annum.
Interest paid on provident fund…
Each year the government notifies the rate of interest payable on provident funds. For example, the current notified rate of interest is 9.5% per annum. Interest is paid on the total of employee and employer contribution. The total interest paid, up to the notified rate of interest, is entirely exempt from tax. It is interesting to understand the effective yield that an individual earns on his provident fund with the help of a small real life example.
Assume that a person contributes Rs.100,000 during the year as contribution to PF. On that he gets a 30% tax rebate under Section 80C (assume he has no other Section 80C investments). That effectively means that he invests only Rs.70,000 of his own money during the year. Let us also assume that the rate of interest is 9.5% notified. That means he earns Rs.9,500 as interest for the year. But this interest is tax free, so in pre-tax terms this works out to an interest of Rs.13,500 (considering 30% tax). So effectively you earn Rs.13,500 per year on an annual contribution of Rs.70,000. That works to a stupendous pre-tax yield of 19.28%. This explains why PF is such a popular investment avenue in India even today.
Withdrawal of Provident Fund balances:
Finally, it is also essential to understand some key provisions pertaining to withdrawal of provident fund balances. There have been a new set of rules that were notified effective June 01, 2015 pertaining to withdrawal of PF balances. Here are some of the key highlights:
- When a person withdraws the PF balance on retirement after attaining the age of 58, the entire balance of PF is entirely tax-free in the hands of the recipient.
- In all other cases, for PF withdrawals to be tax-free, it should have been held for a minimum period of 5 years continuously. It is interesting to understand the definition of 5-years in this case. It does not mean 5 years of continuous employment in the same company but continuation of the same EPF account. For example if you leave a company after 3 years and transfer your PF balance to the new company then it will be treated as continuous service and not as broken service.
- If provident fund balance is withdrawn after completion of 5 years as above, the PF balance is entirely tax-free in the hands of the recipient. If the balance of the PF is withdrawn before the completion of 5 years, then it is liable for deduction of TDS at the rate of 10% of the accumulated balance.
- It is very important to quote your PAN number at the time of withdrawal of PF. If the PAN is not quoted then the PF department will deduct tax at the peak rate of 34% from the PF balance.
- There are some exceptions to the 5-year rule. If an employee gets terminated before 5 years or if the company in question is shut down then the withdrawal of PF balance will be entirely tax exempt in the hands of the employee even though 5 years have not lapsed.
It is essential to understand the subtle nuances of provident funds to make the best of it. Above all, understanding its tax implications is a must.
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