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Economy

Update from Finmin: PPF Is Not Taxable, But EPF Corpus is Taxable at Exit And More

This is an update to our (very popular) post on Clearing the Confusion on how EPF is Taxed in Budget 2016.

The Finance Ministry has released a note confirming EXACTLY what we have said here, despite statements to the contrary made on various TV channels. Here’s the note

Essentially:

  • PPF is unaffected. No change, No tax on exit. 
  • EPF Is taxable at exit. If you earned less than 15,000 rupees a month when you retire, you don’t pay this exit tax. 
  • The idea is to discourage taking full PF when you retire, as a lumpsum. Take 40%, no tax. The remaining 60% if you do take, you are taxed on it (at retirement)
  • Note: it’s 60% of the whole corpus, not interest.
  • If you use this 60% to buy an annuity from an insurer, then there is no tax. Now this needs a clarification that it’s not really taxed – because technically the money comes to you and you buy an annuity, so it’s income in your name. I think the concept may be hidden in the tax code, but I haven’t been able to find it.
  • The annuity pays you a monthly amount. This monthly amount is taxable. (Please don’t believe what someone has “said”. Income from annuities is taxable, nothing has changed there)
  • If you die and the remaining annuity goes to your heirs, they don’t pay tax. (basically, we can’t enjoy our money, our heirs can)
  • Employees and Employers can both contribute whatever they want, but only 1.5L (each) is allowed as an exemption. 
  • People have asked that only the accumulated interest be taxed, not principal. And that the input limits should be removed (currently 1.5L on both employer and employee contributions). They will think about it, so these changes have not yet happened.

Please note.

There is a lot of drama happening. Everyone’s furious. But this has to happen someday – retirement savings have to be taxed at exit as part of the EET regime. However, in this case, it’s piecemeal – firstly, we should have a uniform approach for everyone (so even PPF, Insurers, ELSS etc should have a tax on exit), or nothing should. Secondly, remember that EPF is mandatory for most people and most companies don’t even know they can have employees opt for a lower amount; the EPFO should let them lower that liability. Thirdly, the EPF you pay in is not fully tax exempt so this amounts to double taxation for the richer employees.

The law protects past investments but applies to fresh investments made in the future. EPF should be only used in the most minimum quantities primarily because the quality of annuities in India are waay lesser than equivalent products. An annuity for life with return of premium to your heirs gives you a return of about 6.7% today (Rs. 6,700 per year for one lakh invested) which is taxable. If you had the corpus, you could invest in tax free bonds and get an income of 7.5% tax free. Annuities make no sense to buy, but we now are forced to buy them.

Our Suggestions

At Capital Mind, the EET regime is not something we abhor. But we require a level playing field for all long term tax saving products. If you saved tax going in, you’re going to be taxed getting out. That should apply for everything.

So there are two real problems with the EPF and the EET regime. For many, it’s TET. (Since the entry amount is often paid from post tax income) and thus it amounts to double taxation of the same amount. Imagine you had Rs. 100 and you paid Rs. 30 tax on it, and invested the Rs. 70 into the EPF. The Rs. 70 after many years becomes Rs. 150, and now 60% of it is taxed again! This is not new (dividend distribution tax is a form of double taxation) but is strange to do. A better solution is to simply state that all input into EPF is 100% tax free, and all output is 100% taxed. 

Another problem is that annuities from insurers are crap in India, and the annuity income is taxable. Instead of demanding that the EPF corpus is invested in annuities, the government should state that the money could be invested in a) government bonds and b) tax-free bonds just the same as annuities. With the rider that they cannot sell and must reinvest any principal if it matures. (Otherwise the money gets taxable) People can drip-sell and reduce tax liability on their own. 

Not that this will happen, but still, there’s a need for suggesting solutions other than “roll it all back”.

  • Deep says:

    How can principal be taxed?It is not income .What the revenue secretary has clarified that only interest be taxed is common sense and obvious.Also EPF withdrawal can be made in situations like medical conditions,home building,flat purchase ,marriage ,job loss what would be tax treatment then?

  • Jagan says:

    Looking at the way our uneducated ministers are working in govt. of today. I think we must lower the election period from 5 yrs to every 1 year. Then lets see who gets taxed how much.

  • Viral says:

    Deepak, what is wrong in taking the first step towards pension based society. I think this step of government is justified.
    Also please read the point no. 6 of the clarification issued. Out of 3.2 crs EPFO members, only 60 Lakhs earning upwards of 15000. And out of 60 lakhs, i think not even 6 Lakhs will be there whose EPF amount will be paid from post tax income.
    So your 1st point is not a valid case going by % of people falling in the category.
    And for 2nd point, Annuity products will improve if demand comes because of steps like these..Give it some time.

    • I have been waiting for annuities to improve for SIX YEARS! Come on, that’s long enough for things to improve. SEE: https://www.capitalmind.in/2010/01/low-annuity-returns-in-india/
      Please note that I don’t care about numbers – you cannot have a policy based on today’s numbers but hurts a much larger number tomorrow. the policy is the question.
      I don’t like a pension based society. We will soon learn why, from Japan and the US pension thingies. I want people to manage their own retirment.

      • Jagan says:

        Completely agreed with you Deepak. Who the hell is govt. to tell me how should I manage my retirement? It is my freaking money which I earned out of my own skills. By prohibiting withdrawal until the age of 58 even then it is not going to help since inflation will kill its value anyways by the time one turns 58 yrs.
        Is govt. also proposing to fix minimum 15% net interest payable on such EPF then I would have been ok with the taxes. If the answer is no Then the govt. has to no business to block access to my own money. Just stay away from it.

    • Vineet says:

      Thanks but I would like to manage my own money. They can tax EPF but then it should be voluntary, contributions will drop like a rock I am sure.

  • skb says:

    This is double whammy where we are not allowed to withdraw it until age 58 and then tax it at the end. It is not well thought out and too many confusions. Should be given an option to opt out of employee contribution towards EPF.
    Almost like dragging the person to the gallows and then giving the death blow. BJP just lost my vote.

  • Anand says:

    Deepak, you are right on the employee contribution. Contribution upto 1.5L is not taxed, but is clubbed with other deductions in that category.
    However the entire employer contribution is not taxed.
    Net-net, only the employee contribution in excess of 1.5L is taxed at entry (assuming no other contributions in 80c)
    Today the generic monthly salary structure seems to be around 40-50% Basic and rest as HRA, flexible components. For an employee contribution of 1.8L, this works out to 15k per month PF contribution. Back of envelope calculation with this model puts the monthly gross salary at 2.5 to 3.25L. Do you think the government is going to be worried about this class 🙂

  • Raghav Rajaraman says:

    Thanks for clarifying things.
    With so much idiocy and immaturity at the top levels in the administration (IAS and/or politicians), causing so much confusion, why don’t we:
    A. Go back to first principles
    B. See how other “more mature” systems like the US-401k are designed.
    Some simple first principles:
    1. Design of taxation should avoid unintentional arbitrage.
    For example, in case of income taxes:
    1a. Every income should be taxed once at a pre-determined rate (could be anything between 0-100).
    1b. No income should be taxed more than once
    1c. If there is any arbitrage in taxation for different entities, it should be intentional: designed to provide either incentives or dis-incentives for certain activities that are in “public interest”, thus, indirectly also helping the “private interests” of the private entities being given differential treatments.
    2. Retirement products are meant for encouraging retirement savings, not meant for tax savings or tax avoidance.
    The old system for PF and other income taxes is influenced by arbitrary criteria much more than by first principles.
    But we can see where the new changes violate these first principles in new ways, and contrast that with a 401k or other taxation in the US, where it does NOT violate:
    A. Indians can contribute 12% of basic (plus a 12% company match) to the EPF. This violates (2), a person with a 10 crore basic, would use this as tax avoidance rather than for retirement planning.
    In a 401k, you can contribute only upto $18000, regardless of your very high income. This provides for reasonable savings at retirement, but no more. Because, anything more would be just used as tax avoidance.
    B. In EEE, one would avoid tax completely. This violates (1a). In the new EET, still one could have to pay the tax twice, for the retirement savings above the 80c limit, making it a TET. This violates (1b).
    In a 401k, you deduct your entire contribution (upto 18000) from your income at the time of contribution. But pay income tax on the entire withdrawal, at the time of distribution from a 401k.
    In a 401k, you are taxed exactly once. It does not provide you any tax avoidance, it provides for tax deferral to encourage retirement planning. At retirement, you can withdraw any amount every year. (above a required minimum). This allows you to plan withdrawals based on your expenses in those years, effectively making it an expense-tax, rather than an income tax.
    C. With new changes in EPF they supposedly plan to apply tax on the entire corpus. This makes sense only if the entire original contribution was tax-deductible, otherwise it violates (1b).
    In a 401k, entire original contribution is always tax-deductible. So at withdrawal, the tax is on the *entire corpus*. Not just the gain. This makes sense as you are taxed exactly once. (Note that there is an arbitrage opportunity even here in a US-401k: 401k distribution is also taxed as income tax, not capital gains tax. If income tax rate is more than capital gains tax rate, any arbitrage potentially causes change in behavior: people would invest in bonds in a 401k more, and in stocks in outside investments (stock capital gains taxes are lower than income tax rates). Refer to bogleheads for this.)
    D. EPF is currently mandatory, so the new double taxation also becomes mandatory. This violates (1c). Intentional arbitrage in taxation is should be meant to incentivize or dis-incentivize any desired behavior, it should not force behavior.
    A US-401k is optional. Unfortunately, it is an “opt-in” instead of “opt-out”. Opt-outs work better for most to achieve desired retirement goals, while providing flexibility for those who need independent retirement planning. (But more and more US employers in recent times, do make it an opt-out, thus making it work better for most.)
    E. With the new changes, there are concerns about the dead lock-in of contribution in the plan until 58.
    A 401k, on one hand, provides for pre-mature withdrawal, on the other hand discourages pre-mature withdrawal (but not prevent it) by adding an extra 10% penalty in addition to the regular income tax on premature withdrawal.
    F. There are numerous examples of other arbitrages in India: Eg. if you save money in a money market account, you pay income tax on the interest. If you buy a growth mutual fund that puts money in the same money market account, you pay capital gains tax. The interest accrued in a growth mutual fund is arbitrarily included effectively as capital gains.
    In the US, there is no such arbitrage available. A 2% interest in a savings account or a bond, or a 2% interest in a bond fund attracts the same tax. There is no such arbitrary thing as a “growth” fund. Mutual funds have to distribute the dividends or interest accrued in the underlying instruments, and investors pay tax accordingly. Thus making a mutual fund is only a “medium” of investment in underlying investments, not the “investment” itself.
    G. With all the sloppiness in India in designing these and many other rules and institutions, it only points to the idea that the people at the top (or anywhere else in non-private institutions really) are deeply incompetent, lacking basic understanding about logic, design, behavior. There is a true lack of talent in India. In more mature countries, there is more logical planning even at a city level administration. This penchant for on the fly and arbitrary rules in India only underscores the incompetence. Compare the language in IRS publications to Indian administration publications to see orders of magnitude difference in quality. We have a looooong way to go. (Not that the IRS is the greatest thing ever.)
    Given this, for the ordinary people like us, instead of reacting to every such instance of arbitrariness, and spiraling aimlessly, it will make more sense to take a step back, and anchor ourselves to first principles, and then respond.

  • Sukumar says:

    Dear Deepak
    The EPF has a pension component built inside unlike NPS.
    They are already swindling 8.33% of the Employer contribution (limited to 15000).
    If a person joins at 20 and retires at 58 with Rs.15000 at Basic+da then the max pension can be: Pensionable salary(15000) x Pensionable service (38 years) / 70 (god knows how they arrived at this factor) = 8142/month. This is a fixed amount and will not change until death of the pensioner.
    Contribution to EPS : 15000×8.33%=1250 x 12mon x38yrs with a qtr comp and int rate of 8.75% will result in a corpus of 44.9 lakhs.
    The pension amount works out to 2.18% yield. Now they want to tax the accumulated corpus also. Great Govt. achhe din has come.

  • Hiren Dharamshi says:

    Dear Deepak,
    The limits on EPF withdrawal in itself is against the basic premise of democracy. In most private jobs the Employer PF contribution is part of the CTC, i,e, total Salary component.
    So when a person withdraws his own money from the bank does he needs Government approval, definitely not, then why when from EPF account & that too when he is jobless & require the money to survive. These is draconian.

  • Mehul says:

    What is drip-sale of bonds and how does it reduce tax liability?