What you need to know about taxation of Provident Funds

The Union Budget 2021 proposes to tax the interest income earned if the provident fund contribution of the employee is more than Rs250,000 per year.

Mar 16, 2021 07:03 IST India Infoline News Service

Union Budget 2021 shared some interesting data on how a lot of high-net-worth people in the super-rich income bracket were making the best of the tax breaks on provident fund contributions. There is nothing wrong, but such tax breaks are meant largely for lower- and middle-income groups. Also, when the government gives a tax exemption, there is a cost. To plug that loophole, the government has decided to tax provident fund returns conditionally from 01st April 2021 onwards.

What do the PF taxation provisions say?

The Union Budget 2021 proposes to tax the interest income earned if the provident fund contribution of the employee is more than Rs250,000 per year. The interest earned on any contribution to provident fund above this limit will be taxable at the incremental tax rate applicable to the individual. In other words, it will be taxed just like other income.

Does this apply to PPF or to employee CPF? That is a confusion that a lot of investors have? Will this rule apply only employee PFs or also to PPF? Currently, the annual contribution to PPF is statutorily restricted to Rs150,000 per individual per year. There is a separate cap of Rs250,000 on contribution to PPF, distinct from the CPF limit. However, for now the limit is already at Rs150,000 so this rule is not relevant to PPF.

This also means that PF now will not be entirely EEE any longer. EEE refers to (Exempt, Exempt, Exempt). PFs were tax-free at 3 levels. Firstly, there was a tax exemption on contribution under Section 80C. Secondly, the interest was entirely tax free. Finally, the redemption amount was also free of tax. Under the rules effective from 01 April 2021, the interest earned on PF contributed above Rs250,000 will be taxed, so PF now becomes EET.

Lastly, it must be remembered that this PF tax is a prospective amendment. That means, this rule will only apply prospectively for PF contributions made from 01 April 2021 onwards.  This rule will not be applicable to all the PF contributions till the 31st of March 2021. Also, this rule only applies to employee contributions and not employer contributions.

What is the total income up to which PF tax is not applicable?

That would depend on the contribution made to the PF. Currently, there is a statutory limit of 12% of basic plus DA that you must contribute to PF. To that extent the employer also matches the contribution. However, the employee is permitted to go higher than that level of contribution by contributing to the VPF or the voluntary provident fund. If your total contribution to CPF and VPF surpasses Rs250,000 per year, then the additional interest becomes taxable. Let us look at a case where there is no VPF.

Level up to which PF contribution is tax free Rs250,000 (a)
Current level of statutory PF contribution 12% (b)
Total annual income up to which PF interest is tax-free Rs20,83,333 per year (a/b)
Monthly income for tax-free PF interest Rs173,611 per month

You can say that roughly if your monthly income (basic plus DA) is around Rs175,000, then your PF interest would be tax-free. That is reasonable because it would put most lower- and middle-income earners in the industry outside the ambit of this tax. Only those who are in the upper and super income brackets will be subjected to this PF interest tax. Of course, if your income is lower and your voluntary VPF contribution takes it above Rs250,000 per year, then PF interest would still be taxable.

How will taxable PF interest be calculated?

Let us understand this with the help of an illustration. Rakesh is earning Rs27 lakhs per year and contributes Rs324,000 per year as PF. In addition, he also contributes Rs.76,000 as VPF taking his total contribution to Rs.400,000 per year. We can assume the PF interest rate at 8.5%, which is the extant rate now. Here is how the calculation of tax will appear.

Particulars Total Contribution Tax-free portion Taxable Portion
PF Contribution Rs400,000 Rs250,000 Rs150,000
Interest on PF Rs34,000 Rs21,250 Rs12,750
Exempt PF interest Rs21,250 Rs21,250 N.A.
Taxable PF Interest Rs12,750 Nil Rs12,750

As we can see from the above table, the base exemption of Rs250,000 to PF contribution will be applicable and that proportionate interest will be tax free. In the above case Rs.12,750 interest on PF will be taxable as other income.

How is the interest on PF taxed?

The additional taxable interest (Rs12,750) in the above case, will be treated as other income and hence taxed at the incremental rate of tax applicable to you. The Income Tax department will deduct TDS at 10% under Section 194A. Thus, TDS will be deducted at of 10% of Rs.12,750 or Rs.1,275. This amount will appear in you Form 26AS. However, you still need to file the returns and show this as other income and either pay additional tax or claim a refund of tax, as the case may be!

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