Budget 2021 proposed to levy income tax on interest earned on employee contributions to the Employee Provident Fund (EPF), but not everyone will be affected by this proposal. Only the accrued interest on the part of the annual contribution which exceeds Rs 2.5 lakh will attract income tax. Granted, people with high base salaries will obviously be the most affected, but there are many scenarios in which this tax can impact others with lower base salaries as well. The latter group may be impacted due to the contribution to the VPF or the implementation of the new wage code, among other reasons.

PEF is one of the more stable avenues for regular savings and it becomes important to understand its impact on long term life goals like retirement, especially when doing long term financial planning. Here are the scenarios in which this tax will affect you and not affect you.

Monthly base salary less than Rs 1.73 lakh
If your current base salary is Rs 1,73,611 per month and you don’t contribute to VPF then you don’t have to worry about the tax imposed by this budget. The majority of employees whose current salary is lower than this level will not be impacted by this tax at present. Indeed, the compulsory EPF contribution is 12% of the basic salary. Therefore (12% of Rs 173,611) x 12 months = 2.5 lakh which is the contribution limit above which the interest on the contribution will become taxable.

If you also contribute to VPF
Even people whose contribution to the EPF is less (at Rs 2.5 lakh per year) could contribute to the Voluntary Provident Fund (VPF) which offers the same return and the same tax treatment to investors as EPF. The appeal of this option was really compelling for people with a higher salary, as it offered a fully tax-exempt return combined with one of the highest returns among fixed income investment options with the perceived security of a contingency fund.

What the two tax breaks in the 2021 budget mean for you

Two key announcements in the 2021 budget included interest earned on Contingency Fund contributions exceeding Rs 2.5 lakh per year becoming taxable and the removal of the tax exemption on ULIPs with a premium of over Rs 2.5 lakh per year. We explain what these personal finance issues mean to you.

The maximum contribution to the VPF (including EPF) can be 100% of the basic salary. In the event of an employee contributing equally to the EPF and the VPF, his contribution would be 12% + 12% = 24% of the base salary. Therefore, even those who contribute 24% to EPF and VPF but who have a base salary lower than Rs 86,806 will not be impacted by this tax. However, if your base salary is higher or if you contribute more than 12% to the VPF, you will either have to reduce your VPF contribution or pay income tax under the new rule.

The impact of the new wage code
The new salary code, which is expected to come into force on April 1 of this year, is expected to significantly broaden the definition of salary and thereby increase the basic “salary” on which the EPF contribution is calculated. Since the 12% EPF will then be calculated as a percentage of a higher base “salary”, the annual EPF contribution for many will increase. This will particularly affect those with a lower base salary but higher total compensation.

Thus, if your base salary represents 30% of the total compensation, your base salary will be multiplied by 1.67 and you could end up in the “imposed EPF interest” bracket. In such a scenario, if your current base salary is less than Rs 1,04,167, you may not be affected, but if your salary is higher, you will end up paying interest tax on your additional contribution to EPF.

In case of equal VPF contribution in the above scenario, you will not be impacted if your base salary is Rs 52,083 or less. However, if you have a base salary higher than this, you will either have to reduce your VPF contribution or pay taxes.

High growth sector with many years of service remaining
Many employees may have escaped this tax at the current base salary level. However, that does not guarantee that it will remain so in the future, especially when you have many years of work left and you are in a fast growing industry with high salary levels. If you start with a base salary of Rs 50,000 and increase by 12% each year, in 11 years your salary will exceed the level at which interest on the EPF contribution begins to be taxed.

The EPF contribution of civil servants is calculated as a percentage of their base salary plus the cost allowance. Therefore, these employees will have to perform the above mentioned calculations on this basis.

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