Taxation of EPF contribution above Rs.2.5 Lakh – CBDT Clarification

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The much-awaited clarity on taxation of EPF contribution above Rs.2.5 lakh is finally notified by CBDT on 31st August 2021. It even cleared the dust of what I also assumed. Let us see these clarifications in detail.

Finance Minister in Budget 2021, announced that any contributions from an employee over and above Rs.2.5 lakh are taxable income. I have written an article in this regard (Refer – EPF contribution above Rs.2.5 Lakh Taxable )

The reason quoted during the Budget 2021 is as below.

“Instances have come to the notice where some employees are contributing huge amounts to these funds and entire interest accrued/received on such contributions is exempt from tax under clause (11) and clause (12) of section 10 of the Act”

Let us take two examples. Assume that your monthly contribution is Rs.20,000. This means your yearly contribution is Rs.2,40,000. This is below the Rs.2,50,000 limit. Hence, the interest earned on this contribution is as usual tax-free.

However, assume that you are contributing another Rs.10,000 (as VPF) along with a default Rs.20,000 monthly contribution. Then the yearly contribution will be Rs.2,40,000 (default EPF contribution) and Rs.1,20,000 (VPF contribution). So in total, you have contributed Rs.3,60,000, which is above Rs.2,50,000 limit set during this budget.

Hence, the interest earned up to Rs.2,50,000 is tax-free. Interest earned on the remaining Rs.1,10,000 is taxable for you. You have to pay the tax on it as per income tax slab (Refer to the latest Income Tax Slab at “Latest Income Tax Slab Rates for FY 2021-22 / AY 2022-23 | Budget 2021 Key Highlights“.

Taxation of EPF contribution above Rs.2.5 Lakh – CBDT Clarification

After this Budget announcement, there was confusion that whether whatever interest earned on an employee contribution of over and above Rs.2,50,000 will be taxed only on that year or interest earned on subsequent year’s interest is also taxable (like Bank FDs).

As there was no clarity from Finance Ministry and CBDT, I also assumed that first-year interest is only taxable but subsequent years earning on such compounding is not taxable.

However, CBDT clarified this confusion and notified as below.

From now onwards you have two EPF accounts.

a) Non Taxable EPF contribution account-

This account is the balance of all the below-mentioned balances.

  • Closing balance of your EPF account as on 31st March 2021.
  • Any contribution which you make every year which is less than Rs.2,50,000 a year and your employer EPF contribution.
  • Interest earned on such employee and employer share.

b) Taxable EPF contribution account-

  • Any contribution above Rs.2,50,000 a year by an employee from FY 2021-22 onwards.
  • Interest earned on such contribution on yearly basis.

Now from this taxable EPF contribution account, whatever the interest you earn on yearly basis is taxable for you like Bank FD. Let me give you an example.

Let us assume in this account the opening balance from FY 2021-22 is Rs.1,00,000. Assumed that EPF credited Rs.8,000 as interest on this ( @ 8%), then you have to pay the tax as per your tax slab under the head of “Income from Other Sources”. If you are falling under the 30% tax slab, then you have to pay Rs.2,400 interest on this income.

From the subsequent years also, whatever the yearly interest you earn from this account is taxable as per your tax slab. Hence, you may treat this account as if FD account.

Let me explain the same with the below image for your better understanding.

Taxation of EPF contribution above Rs.2.5 Lakh

Is it still better to invest more than Rs.2.5 lakh in EPF?

In my view, YES and NO. Because after this CBDT clarifications, it is evident that taxation is huge on such higher contributions. Earlier I wrote a post that it is still BETTER mainly because of no clarity from CBDT on the taxation of such accounts from subsequent years (Investing more than Rs.2.5 Lakh in EPF is still the BEST strategy!!).

The current high-interest rate of EPF (currently at 8.5%), which no other fixed instruments offering you safely. Hence, compared to other debt products available (FDs or Debt Funds), I feel it is worth continuing.

However, going forward if interest rates fall drastically, then your money will get locked with high default taxation you have to pay on yearly basis.

Hence, the alternatives now in front of us are like using Gilt Constant Maturity Mutual Funds (use them only if your retirement is more than a decade), increasing your PPF contribution (by opening the account in your spouse name) or use NPS Tier 2 account by selecting maximum exposure towards Government Securities.

However, do remember that in the products like Gilt Constant Maturity Mutual Funds or NPS Tier 2 Government securities, volatility to interest movement is high. You are just avoiding the default or downgrade risk. But volatility due to interest rate movement is there always. Hence, take a call based on your risk appetite.

Any other alternatives? Let me know, please 🙂

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