Should you still invest more than Rs 2.5 lakh in EPF?

The Budget 2021 changed the EPF interest taxation rule (details here). Now if the employee contribution to PF (via EPF and/or VPF) exceeds Rs 2.5 lakh in a year, then the interest on the additional amount (above Rs 2.5 lakh) will be taxable as per employee’s income tax slab.

This move is expected to impact specifically the high-income salaried individuals.

So if your total employee PF contribution is less than Rs 2.5 lac a year, then you have nothing to worry about as you are below the limit where interest taxation kicks in. But if your total employee EPF contribution (both mandatory and voluntary via VPF or Voluntary Provident Fund) is more than Rs 2.5 lakh, then you need to rethink your options as the interest earned on the excess amount will be taxable as per your slab now.

Note – The new provision only takes into account employees’ contribution and not employer’s (or the total contribution) to the provident fund during any year.

There is no doubt that when it comes to retirement planning, EPF is the best debt instrument for your retirement savings. Given its exempt-exempt-exempt nature (till now), there was nothing to match this instrument on the debt side of the portfolio.

So let’s discuss a bit that whether investing more than Rs 2.5 lakh in EPF is still a good strategy?

I think it is. Even with the new taxation rule. Here’s why.

The first reason is that the post-tax returns are still decent and better than many available debt investment options.

Let’s say your mandatory EPF contribution, i.e. employee contribution is Rs 20,000 per month, i.e. Rs 2.4 lakh per year. But you wanted to increase your PF savings and hence, had decided to increase contribution via VPF of additional Rs 30,000 per month, i.e. Rs. 3.6 lakh per year. Now, your total (employee) contribution is Rs 2.4 lakh + Rs 3.6 lakh, i.e. Rs 6 lakh. This is above the new tax-free Rs 2.5 limit. Right? So the interest on the excess amount of Rs 3.5 lakh (i.e. Rs 6 lakh – Rs 2.5 lakh limit) will be taxable.

Note – Employer contribution is not applicable for this rule change

As per the current EPF interest rates, let’s say you get 8.5% annual interest on your EPF balance.

So 8.5% interest earned on the excess amount of Rs 3.5 lakh is Rs 29,750 (This is just a simple calculation to highlight the point. The actual interest figure will vary as the EPF interest is computed monthly but deposited only once at the end of the financial year as detailed in this EPF calculator)

So you need to pay tax as per your slab on this amount only:

• If you are in 30% slab, then you pay Rs 8925 as tax and your post-tax return becomes Rs 20,825.
• If you are in 20% slab, then you pay Rs 5950 as tax and your post-tax return becomes Rs 23,800.
• As for the 5% or 10% tax bracket, I am assuming that you if you are contributing Rs 6 lac a year in EPF, then you can’t be in 5-10% tax bracket. Right?

So that is your tax on EPF interest on employee contributions over Rs 2.5 lakh in the above example.

Think about it. If you belong to the highest tax bracket then you are still getting close to 5.95% post-tax returns (i.e. 30% tax on 8.5% interest) on interest on contributions above Rs 2.5 lakh. For the amount below Rs 2.5 lakh, you are still getting 8.5%. And even the 5.95% is better than what is available in other debt instruments currently.

PPF is one option where you can around 7.1% (check for latest PPF interest rate). But there you can only invest Rs 1.5 lakh per year and not more as per the limits of Section 80C. In fact, if you properly evaluate the difference between VPF vs PPF, it is the VPF that is a much better choice for those who have this option available to them. By the way, PPF is a decent option in its own right. And it is not linked to your employment so that is one another thing in its favour.

Debt funds can be one option but debt fund returns aren’t guaranteed and you will be taking some inherent risks – which is fine if you want to but it’s nowhere close to risk-free nature of EPF. It is always good to know what debt funds are not.

What else?

The second important point is that it’s true that the interest on the excess amount over Rs 2.5 lakh per year is taxable. But this interest is not taxable in subsequent years. And this is very important to understand.

Here is what the Budget Memo 2021 (link or download here) says about this:

“provisions of these clauses shall not apply to the interest income accrued during the previous year in the account of the person to the extent it relates to the amount or the aggregate of amounts of the contribution made by the person exceeding two lakh and fifty thousand rupees in a previous year in that fund, on or after 1st April 2021, computed in such manner as may be prescribed.“

So if I were to use the previous example, then the 8.5% interest earned on the excess amount of Rs 3.5 lakh, which was Rs 29,750 will become part of the principal from next year. And hence, this will not be taxed and become tax-free from subsequent years.

To summarize, the new taxation (of interest on contribution above Rs 2.5 lakh) is applicable only in the year in which you actually contributed more than Rs 2.5 lakh. From the next year onwards, any interest you earn from this excess amount (or interest on interest from previous year’s excess amount) will be tax-free like earlier. So from a year onwards after you exceeded the Rs 2.5 lakh limit, you again get the normal EPF interest rate of 8.5% even after taxes. This is a key point and clincher in favour of EPF still!

Note (edited to add) – It’s possible that there might be a different interpretation of this rule given the wordings and also, maybe the interest earned on the excess contribution (above Rs 2.5 lakh) may be taxable in future financial years too. The government might issue a clarification with this regard soon. As and when that happens, I will update the article accordingly.

Further Reading – How will EPF contributions above Rs 2.5 lakh be taxed? With 2 EPF accounts!

Also read – How much VPF can you invest to earn tax-free interest on EPF?

So if you can invest more than Rs 2.5 lakh in EPF in a year, then it’s still fine even after the new taxation rule.

You might still tweak your PF investment strategy to maximize PPF contribution to up to Rs 1.5 lakh annual limit and invest the rest via regular voluntary deduction via VPF into your EPF account. That way, at least you can get comparatively higher post-tax interest on Rs 1.5 lakh in PPF than the post-tax returns of EPF. Once you have made your mandatory contribution to EPF and exhausted the Rs 1.5 lakh PPF limit, then you can invest an additional amount in VPF. Do note that this is only about the debt side of your portfolio. You will still need to invest in equity via equity fund SIPs to have a well-rounded portfolio for your long-term investments.