There’s a lot of confusion about the whole EPF taxation thing. Let us explain.

  • Employees put money every month into their EPF (12% of salary) and the company puts another 12%.
  • This money saves tax under section 80C so it’s exempt at entry
  • Then it accrues interest each year, but you pay no tax on that interest. (exempt on accrual)
  • Then when you turn 58, you get all the money, tax free.  (exempt at exit)
  • This was the EEE regime.
  • This is sadly coming to an end.
  • Now due to Budget2016, when you exit, the amount of money you get when you exit will be taxed. But not all of it!

Unravelling the EPF mess

First, let’s understand this:

The amount of money you have put in till now, and the interest it will get till you retire – that amount is still exempt at tax when you exit. That doesn’t change.

From 1 April 2016, whatever money you put in, that money (plus it’s interest) is taxed when you exit.

How Much?

The tax is:

  • 40% of that corpus is tax free. 
  • 60% is added to your taxable income and thus, taxed.

This is complex because you have to figure out, when you exit, how much of that money was for what you paid before 1 April 2016, and how much was after, and then apportion the amounts. This requires serious math skills especially if the amount of interest every year is different!

Then, you have the big issue: Tax applies not on the gain, but on the whole amount. Take an example. Assume I put in Rs. 10,000 a month, starting 1 April 2016, for 10 years. That’s Rs. 12 lakh. 

Let’s say my exit corpus is something like 20 lakh.  (Note: This is a yield of 9.5%, way higher than current interest rates of about 8.8%)

You’re thinking: I put Rs. 12 lakh, it’s now Rs. 20 lakh, so I made Rs. 8 lakh, no? Even if I get taxed, I should get taxed on the Rs. 8 lakh? (Or, if you give me inflation adjustment, it might even fall to Rs. 6 lakh?)

Answer: Are you kidding me?

The EPF tax applies on the FULL amount. So of the 20 lakh, only Rs. 8 lakh (40%) is tax free. The remaining 12 lakh rupees get added to your income and taxed! If you’re in the 30% tax bracket, you will pay Rs. 4 lakh as taxes, taking your post tax return to Rs. 16 lakh – which won’t even beat inflation. Plus, note that they just taxed your half of your real gains!

You can complain but that’s how it is. 

Some will tell you – look, you saved taxes when getting in, no? But EPF contribution is only one part of the 80C limit – which you can get if you have paid kids school fees too, or had a housing loan principal paid back, or invested in equity taxsaver funds, or bought insurance policies, or bank 5 year tax-saving deposits. Any of these gives you the same exemption, and if you have put in the EPF amount too, you’re hosed. Plus, if your EPF contribution exceeds 150,000 a year you never got the tax benefit getting in. 

Don’t Invest For Taxes

If you invested in EPF for tax reasons, you will find it was futile. The end-tax now is very high, and the only thing which saves you is that your contributions till now are tax free on exit. But anything going forward is not worthwhile!

Sadly, EPF is compulsory. But there’s an option. 

Companies have the ability to say they will cap EPF inputs at Rs. 800 or so per person. (2% of salary or Rs. 800 per month, whichever was lesser)

Note: I have been told this has been changed – the min salary was 6500, which is upped to Rs. 15,000, in 2014. So you can cap it to 12% of 15,000 which is Rs. 1800 per month.

Then no matter how much your salary is, you only pay Rs. 1800 per month. We took that option in a company I was in earlier. This option is now better since the exit option ensures your real tax is very high when you do exit – so no point paying 12% of your real salary when you can pay a max of Rs. 1800. However, not every company gives you this option. (And apparently, you have to choose that you cap at 15K or you pay for full basic as a uniform policy across all employees. I’m not even sure if you can change this policy after you’ve started one way)

But it’s clear now: Don’t invest because of the tax saving based on existing tax regimes. The government can change on you and can change fast. Your money will be at stake. This time they grandfathered the proposal (as in, allowed current corpus to be tax free) but they may not do it every time. 

The Last Word on the EPF Thing

EPF is simply EET (Taxed at Exixt) now, and companies should be allowed to shift to the NPS for superannuation. The taxes make it less worthwhile (like I have shown earlier). However that applies only on exits at one shot – currently that’s the option. But things are going to be clarified – you may be able to buy an annuity and defer the tax.

Also note, you do not pay tax at exit on your corpus as of 31 March 2016. Current payments have been completely grandfathered at exit. So don’t rush to withdraw or remove money; you don’t have to. (Anyhow, you can only withdraw what you pay in, with a notification in Feb. Your employer’s contributions are not withdrawable till age 58) 

PPF is okay. It’s still exempt, in full, on maturity. 

NPS is now on par with the EPF, but probably wins because its yields have been higher.

In all cases, the tax on EPF on exit, and the lack of full availability of that tax on input (since 80C limits are taken by other things also) means you get a horrible retirement package which won’t beat inflation. There’s not much you can do though – as an employee, you can’t exit easily. You don’t have to exit now, because anyhow nothing that you put in till March 31, 2016 will be taxed even on exit. But after that, you need to understand that your retirement return immediately becomes substandard. 

Update: Minister of State for Finance Jayant Sinha has confirmed on twitter that they will issue certain clarifications. Apparently, this rule may also apply to PPF (current rules don’t include PPF) and that if you transfer the 60% money to an annuity you will not be taxed on that 60%. And then, supposedly annuity returns (monthly payments) may not be taxed. This is all in the air, because I cannot find any of it in the finance bill and will need an addendum.

Overall, this move is a move to the EET regime. This would be fine – fully exempt on entry and accrual, and fully taxed on exit. That’s a good thing to have in general but remember that in EPF, there are multiple issues:

  • EPF entry is not all non-taxable – entry of Rs. 3 lakh (1.5 lakh of yours, 1.5lakh of employers) is non taxable, anything more is not. Even your contribution is within 80C, where you may have exhausted limits due to investments in other securities/expenses – children’s education, housing loan principal etc. (But then exit is also not taxed 100%, only 40%)
  • EPF is not optional – for all companies > 20 employees, it’s compulsory. And most don’t make it easy for an employee to only take the Rs. 1800 per month option – they actually pay 24% of their salary. (People negotiate the FULL salary – which includes the employers contribution, as a Cost-To-Company – the company will happily pay you the excess if your EPF payment is lower, say because you already have other 80C exemptions, if you’re okay getting taxed)
  • EPF is the only instrument going EET. Other such things – Insurance payouts and ELSS are still EEE. That makes no sense.

So if what Mr. Sinha says is right, then we must also make EPF optional (versus say an NPS or say self invested lower retirement savings) and will see it go 100% tax free at entry too. (Then they can tax 100% at exit, which can be an annuity or something else) Also other long term saving might also go into the “taxed at exit” mode. This will happen in later years. You have to be careful about how the regime is changing – what they say is “not taxable” now, can become taxable later. Don’t bet on taxes for your retirement kitty. 

Update: PPF Is Not Taxable, Whole Corpus Is

The Finance Ministry has released a note confirming EXACTLY what we have said here, despite statements to the contrary made on various TV channels. Here’s the note

Essentially:

  • PPF is unaffected. No change, No tax on exit. 
  • EPF Is taxable at exit. If you earned less than 15,000 rupees a month when you retire, you don’t pay this exit tax. 
  • The idea is to discourage taking full PF when you retire, as a lumpsum. Take 40%, no tax. The remaining 60% if you do take, you are taxed on it (at retirement)
  • Note: it’s 60% of the whole corpus, not interest.
  • If you use this 60% to buy an annuity from an insurer, then there is no tax. Now this needs a clarification that it’s not really taxed – because technically the money comes to you and you buy an annuity, so it’s income in your name. I think the concept may be hidden in the tax code, but I haven’t been able to find it.
  • The annuity pays you a monthly amount. This monthly amount is taxable. (Please don’t believe what someone has “said”. Income from annuities is taxable, nothing has changed there)
  • If you die and the remaining annuity goes to your heirs, they don’t pay tax. (basically, we can’t enjoy our money, our heirs can)
  • People have asked that only the accumulated interest be taxed, not principal. And that the input limits should be removed (currently 1.5L on both employer and employee contributions). They will think about it, so these changes have not yet happened.
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