Now, however, the story has changed. Those who routinely get a large EPF deduction need to pay attention. From this year onwards, the tax-free interest income is available only up to an annual EPFO deposit of Rs.2.5 lakh. If there is no employer contribution, the limit will be Rs.5 lakh. For an annual contribution above this limit, the interest earned will be added to your taxable income as in the case of any other deposit. As with banks and other deposits, TDS will be deducted quarterly.

To implement the new rule from this year on, the EPFO will maintain two separate accounts for all those who start contributing more than Rs.2.5 lakh a year. One of the EPF accounts will continue to operate as it currently does. In the other account, the amount will be taxable and TDS will be deducted.

The taxable part of the balance and its interest income will accumulate here. This part of the EPF will be just another deposit (for the time being) with a slightly higher interest rate than that for bank or other deposits. However, the long lock-in period in the EPF becomes more relevant, changing the equation completely.

Let’s consider an example, wherein you contribute Rs.3 lakh a year to the EPF over and above the Rs.2.5 lakh limit. Let’s also assume that the interest rate from now onwards is 8% and that your marginal tax rate is 30%. So, every year, you will earn 8% on your accumulated amount and pay 30% of that earning as income tax. To simplify, I’m considering the entire annual inflow and tax as a single event; this is not how it happens, but will suffice for my argument here.

Had Rs.3 lakh a year gone into the nontaxable EPF account, it would have grown to Rs.1.48 crore in 20 years. However, in the taxable account, given the above conditions, it will accumulate to only Rs.1.12 crore. The continuous taxation means that the true post-tax internal rate of return is just 5.62%. So, it’s a deposit with a decades long lock-in period and a return of 5.62% a year. Does this seem like a good deal to you? No, not to me either.

So what should you do? Here’s a heretical idea. Instead of a taxable EPF account, why not invest this money in an equity fund? You could choose a conservative largecap fund or, perhaps, a Sensex or Nifty ETF. Of course, there would be volatility, but over 20 years, it would get evened out. The returns would almost certainly be better. Let’s run the same calculation again, but let us assume that these 20 years are exceptionally damp for equity and returns are also the same 8%. Let the only difference be the taxation.

In this case, with the same inflow, you would end up with Rs.1.39 crore instead of Rs.1.12 crore. Remember, in an equity mutual fund, the money would accumulate without taxation and will be taxed once at the end when it is withdrawn, and that too at only 10%. The true internal rate of return here would be 7.48%. In equity, 20 years of uninterrupted accumulation with just one taxable event means that 8% gets reduced to 7.48%. In reality, you get a far higher return with equity.

Taxability makes the extra contribution to the EPF a highly questionable idea. I don’t think anyone who has read the above argument carefully would need any more convincing about additional contribution.

By the Author:CEO, VALUE RESEARCH