Explained: New rules of taxing interest on EPF; how to calculate

The Central Board of Direct Taxes notified the rules to calculate taxable interest in PF on Wednesday

The Finance Ministry has notified rules for calculation of taxable interest on employee contributions to provident fund of over Rs 2.5 lakh per annum (for private sector employees) and Rs 5 lakh (for government sector employees). As per the rules, for the sake of calculation, separate accounts within the provident fund account shall be maintained beginning 2021-22 for taxable and non-taxable contributions made by a person.

Tax on EPF contribution

In her Budget for 2021-22, Finance Minister Nirmala Sitharaman had capped the tax-free interest earned on provident fund contribution by employees and employers together to a maximum of Rs 2.5 lakh in a year in an attempt to dissuade high earners from parking their surplus in what is supposed to be the 'common man's retirement fund.'

The new rules will only impact those who contribute more than Rs 2.5 lakh a year to EPF and will not affect salaried individuals’ existing provident fund corpus or the aggregate interest accrued on that.

Read | Ministry of Finance notifies rules for calculating taxable interest in provident fund account

Earlier this year, the government had amended the Finance Bill, 2021 to increase the threshold limit in the provident fund to Rs 5 lakh per annum for which interest would continue to be tax-exempt. This exemption, however, is subject to condition that the up to Rs 5 lakh contribution does not include the employer's contribution beyond the statutory limit of up to 12 per cent of the basic pay.

Rules behind the tax

The Central Board of Direct Taxes (CBDT), which notified the rules to calculate taxable interest in PF on Wednesday, has put Rule 9D in the Income-tax Rules, 1962. It specifies that separate accounts within the PF accounts shall be maintained clearing segregating the taxable and non-taxable contributions to PF along with interest thereon.

The Employees’ Provident Fund Organisation (EPFO) has a task at hand to formalise the separation of contributions in separate accounts and is expected to take time. To put it in context, EPFO has over six crore subscribers. The Rs 2.5 lakh limit covers around 93 per cent of the people who are EPFO subscribers and they will continue to get assured tax-free interest. Hence, small and medium taxpayers will not be impacted by the step.

The CBDT has said that closing balance of FY21 (as on March 31, 2021) and the interest on it will be non-taxable contribution and the taxable contribution will comprise of contribution made from FY22 and the subsequent years in excess of the threshold limit.

Tax calculation on EPF contribution

For an employee in the tax bracket of 30 per cent, the interest income on EPF contribution over Rs 2.5 lakh will get taxed at the marginal tax rate. If a person is contributing an amount over Rs 2.5 lakh, say Rs 3 lakh, in a financial year to the EPF scheme, interest will be earned at the rate of 8.5 per cent. Under the new law, 30 per cent of this interest will make a part of income for the income tax calculation.

According to the notification, this interest income will be taxed every year. An employee’s additional contribution to PF in FY22 will be taxed in FY23 and all subsequent years.