The impact of EPF taxation | Value Research The arithmetic of large EPFO contributions has changed because of taxation. Savers should examine if these still make any sense.
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The impact of EPF taxation

The arithmetic of large EPFO contributions has changed because of taxation. Savers should examine if these still make any sense.

If something is good, then more of it must be better, right? Maybe not always, but this is a firm belief of EPF fans in India. For long, contributing extra to EPF than the requirement was standard practice among salaried individuals. This extra contribution was not matched by the employer, nor did it provide any kind of a tax break on the invested amount. However, in every other way, it was not a bad deal. The interest earned was not taxable, the rate was always high compared to alternatives, and there was an effective sovereign guarantee on the money. The lock-in was onerous, but given the high and tax-free interest rate, it was a good trade-off.

Now, from this year onwards, the story has changed. Those who routinely get an extra-large EPF deduction need to pay attention. From this year onwards, the tax-free interest income is available only till an annual EPFO deposit of Rs 2.5 lakh. If there is no employer contribution, the limit will be Rs 5 lakh. For an annual contribution above that limit, the interest earned will be added to your taxable income, just like any other deposit. As with banks and other deposits, TDS will be deducted quarterly. To implement this, from this year, the EPFO will maintain two separate accounts for all those members who, from now on, contribute more than Rs 2.5 lakh in any one year. One of those accounts will continue to operate normally as EPF accounts currently do. At the same time, the other will be taxable from which TDS will be deducted and where the taxable part of your balance and its interest income will accumulate.

From now on, this part of the EPF is just another deposit with (for the time being) a somewhat higher interest rate than banks or other deposits. The other negative part of the EPF, the long lock-in, becomes more relevant. This changes the EPF equation completely. Let's see exactly how much it changes. Let's take an example in which you contribute Rs 3 lakh a year to the EPF over and above the Rs 2.5 lakh limit. Let's also assume that the interest rate from here on is 8 per cent and that your marginal tax rate is 30 per cent. So every year, you will earn 8 per cent on your accumulated amount and pay 30 per cent of that earning as income tax. To simplify our example, I'm considering the entire annual inflow and tax in a single event - that's not how it happens but will suffice for my argument.

Had this Rs 3 lakh a year gone into non-taxable EPF, it would have accumulated to Rs 1.48 crore in twenty years. However, in the taxable account, with the above conditions, it will accumulate only to Rs 1.12 crore. Continuous taxation means that the true post-tax internal rate of return is just 5.62 per cent. Does that sound like a good deal to you? A deposit with a decades-long lock-in with a return of 5.62 per cent a year? Me neither.

So what should you do? Here's a heretical idea? Instead of a taxable EPF account, why not invest this money in an equity fund? You could choose a conservative large-cap fund or perhaps a Sensex or Nifty ETF. Of course, there would be volatility, but over twenty years, it would all get evened out. The returns would almost certainly be better. Let's run the same calculation but let's assume that the twenty years are exceptionally damp for equity and the returns are also the same 8 per cent. Let the only difference be the taxation.

In this case, with the same inflows, instead of Rs 1.12 crore, you would end up with Rs 1.39 crore! Remember, in an equity mutual fund, the money would accumulate without taxation and would be taxed once, at the end, when it is withdrawn, and that too at only 10 per cent. The true internal rate of return here would be 7.48 per cent! In equity, twenty years of uninterrupted accumulation with just one taxable event means that 8 per cent gets reduced to 7.48 pe rcent. And in reality, you would get a far higher return in equity anyway.

Taxability makes an extra contribution to EPF a highly questionable idea. I don't think anyone reading the above carefully would need any more convincing.

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