Budget 2021 EPF tax impact: Investors shifting surplus to NPS, albeit slowly

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Finance Minister Nirmala Sitharaman did not introduce new taxes or the dreaded COVID-19 cess in Union Budget 2021, as was speculated, much to taxpayers’ relief, but her employees’ provident fund (EPF) googly caught many unawares.

Interest on ‘excess’ EPF contribution now taxable

She decided to tax interest on annual EPF contributions of over Rs 2.5 lakh (Rs 5 lakh for government employees). It was primarily aimed at high earners who benefitted from EPF’s high tax-free returns (8.5 percent for financial year 2021-22). But, it also affected employees who voluntarily direct an amount that is higher than the statutory limit of 12 percent of basic pay and dearness allowance.

This contribution, known as VPF, is simply an extension of EPF and is eligible for tax deductions of up to Rs 1.5 lakh under 80C. The interest earned is tax-free, as is the amount you receive at maturity. Tax-free returns of 8.5 percent made it a highly attractive investment option for employees across income slabs. However, starting this year, such employees will not have the luxury anymore – interest on the contribution that exceeds Rs 2.5 lakh will be added to your income and taxed as per the slab rates applicable to you. So, if you are in the 30 percent bracket, your post-tax returns will work out to just 5.8 percent.

Now, if your annual basic salary is over Rs 21 lakh, there is very little that you can do. As per the mandatory requirement, 12 percent of the basic will be deducted as your contribution, to be invested in EPF, along with your employers’ matching contribution. But if you have been investing in VPF and are now looking for tax-efficient options, you need to evaluate other alternatives.

Switch to NPS

This is  why tax experts are advising their clients to move the ‘excess’ EPF  contribution to other retirement avenues such as the National Pension System (NPS) or equity mutual funds. However, the response is mixed. “We are recommending a switch to NPS, but the number of people who have done so is on the lower side. People have indeed started diverting their excess VPF contribution to NPS, but changing old habits is not an easy task. It will take some time,” says Sudhir Kaushik, Co-founder and CEO, Taxspanner.com. Unlike NPS, where you have to open the account and complete some paperwork, investing in VPF is much simpler, as all you need to do is increase your contribution through your employer.

Some tax planners have seen significant shift in mindset. “Nearly all our clients who were investing higher amounts through the VPF route have now switched to NPS. It offers higher returns compared to EPF, besides several tax benefits,” says Vaibhav Sankla, Principal BillionBase Camp Family Office. Contributions to NPS of up to Rs 1.5 lakh can be claimed as deduction under section 80C. An additional deduction of Rs 50,000 is also available under section 80CCD (1B). Employers’ contribution of up to 10 percent of your basic salary is eligible for tax break under section 80CCD(2) – you can choose this option if your employer offers it. However, keep in mind that if the sum of your employers’ contribution to your NPS, EPF or superannuation funds exceeds Rs 7.5 lakh in a financial year, the additional amount will attract tax per the marginal slab rate applicable to you. “If your employer’s contributions breach this cap, then negotiate with your company on your salary structure – you would be better off contributing to these retirement funds yourself,” says Sankla.