Among all the Budget announcements, the one that may have got the maximum attention is the taxability of Employee Provident Fund (EPF) withdrawals.
Considering that you will be entering the work-force soon and may be offered a salary package with subscription to the EPF, it makes sense to understand what the hue and cry is all about. This may also help you understand your pay structure and savings needs better.
How EPF works
When you are just 20-something, raring to move up the corporate ladder and make good money, you may not worry about what you will do when you are 60. But remember, Rome was not built in a day. As much as you may be interested in getting a higher take-home salary, pay structures normally are designed to retain a part of your salary as savings towards your later life. Hence, the compulsory deduction from salary towards EPF or towards contribution to other superannuation funds.
Under EPF, 12 per cent of your basic pay and dearness allowance is deducted every month and credited to the EPF account created in your name. The employer will also make a matching contribution. You will earn an annual interest on the corpus at rates notified by the government each year. In the past few years, this has hovered around 8-9 per cent per annum.
Even if you change jobs over the years, in most cases, you can transfer the same EPF account to your new employer. While part withdrawals to meet certain needs are allowed, to discourage dipping into what is supposed to be your retirement kitty, a few conditions are attached. When you decide to hang up your boots, you can withdraw the entire sum, which would make a tidy corpus for your post-retirement needs.
EEE vs. EET
Though the 8-9 per cent return is nothing earth-shaking, what made the EPF attractive was the tax benefits at various levels. On contribution to the fund, along with other expenses such as payment of insurance premiums or repayment of principal for your home loan, your EPF contribution can also be claimed as a deduction from your total income before calculation of taxes.
Besides, the interest earned as well as the withdrawal was tax-free. This exemption at all three levels gave the EPF the most coveted ‘EEE’ or ‘Exempt-Exempt-Exempt’ status. Barring the Public Provident Fund or the PPF which is a 15-year scheme, not many long-term savings carry this status. Other options for building a retirement corpus, such as retirement mutual funds or the National Pension System (NPS), do not enjoy freedom from taxes at all three levels. With Budget 2016, this landscape has changed.
EPF has been stripped of the ‘EEE’ status as it was announced that for contributions made beginning this year, while up to 40 per cent of the withdrawal is tax-fee, 60 per will be taxable. In effect, EPF has moved from being ’EEE’ to Exempt-Exempt-Taxable’, or an ‘EET’ structure. It was later clarified by the Finance Ministry that if the 60 per cent corpus was invested in an ‘annuity’, it will not be taxed.
Annuities are typically offered by insurance companies where, upon investing a lumpsum (called ‘single premium), you start getting immediate monthly payouts to take care of your expenses after you stopp working. But linking the condition of non-taxability to investment in an annuity is not sound. Investing the EPF corpus in fixed deposits that give monthly /quarterly interest payouts, may not be a bad idea. These FDs may even give out higher interest than annuity. But if you want to do this, you may end up paying a huge sum in taxes, thus decimating your corpus.
Other savings options
In effect, with the move to tax the EPF withdrawals, you cannot depend on EPF alone for the evening of your life. You need to be more nimble on your feet with respect to saving for your future. As soon as you start earning, you will have to set aside monthly sums to be invested in safe mutual funds. Investing in the equity market when you are young makes tremendous sense as you won’t have many other financial commitments and can afford to take higher risk to earn higher returns.
You can also open a PPF account with banks/post-offices. PPF currently enjoys EEE status. The PPF has a shorter maturity period of 15 years but you can roll it over in blocks of five years, thus supplementing your long-term savings needs. Finally, the National Pension System (NPS) is also a good avenue for long-term savings. The NPS invests in a combination of corporate/government debt instruments and equities and can give higher returns than the EPF or PPF, which are purely debt-based investments.