The Type Of Provident Fund You Invest In Could Affect Your Post-Tax Returns

Employees contribute a portion of their salaries each month, thinking that the provident fund is a retirement planning tool. Taxation is a key aspect that impacts the result of such a planning process, which in turn depends on the type of provident fund that the employee is contributing to.

There are three types of provident funds: Statutory Provident Fund, Recognised Provident Fund, and Unrecognised Provident Fund. To know the final tax implications, one has to look at these funds individually.

A statutory provident fund under the provisions of the Provident Fund Act 1925 can only be set up by certain organisations.

The biggest employer that maintains this type of fund is the government, along with other semi-government organisations. Several other well-known entities that maintain such a fund are local authorities, railways, universities, and even other recognised educational institutions.

The employee’s contribution to the statutory provident fund is deductible under Section 80C of the Income Tax Act. The interest earned is also tax-free in the hands of the employee. From the financial year 2021–2022, if the contribution of the employee is more than Rs 2.5 lakh in a year, then the interest earned on the amount that exceeds this limit is taxable. In addition, the lump-sum amount that is paid at the time of retirement or termination of service is also tax-free in the hands of the investor.

Any company with more than 20 employees can set up a recognised provident fund under the Employees Provident Fund and Miscellaneous Provisions Act of 1952. Those with fewer than 20 employees can also join.

There are two ways in which the money is handled. The employer can choose to direct the amount towards the government scheme set up and managed by the Employees Provident Fund Organisation or EPFO. In this case, no additional condition needs to be met to be called a recognised provident fund.

However, if the employer maintains its own scheme, a trust needs to be created by the employers and employees, and the funds should be invested in accordance with the conditions laid down in the Provident Fund Act 1952. If this happens and the Commissioner of Income Tax recognises the trust, then it becomes a recognised provident fund.

For such funds, if the employer’s contribution is more than 12% of the salary, then it is taxable. The employees’ contribution will get the benefit of a deduction under Section 80C of the Income Tax Act. The interest that is earned on the fund will be tax-free (if it is less than 9.5%), and the amount received at the time of retirement will also be tax-free in the hands of the receiver.

A basic condition that needs to be met is that there should be a continuous period of service of five years for the receipt of retirement or termination of service to be tax-free. The new provision from the financial year 2021-22 is that if the contribution of an employee is more than Rs 2.5 lakh a year, then the amount of interest earned on the excess amount will be taxable. This is also applicable here.

Any provident fund that manages its own money and is not recognised by the Commissioner of Income Tax would be classified as an unrecognised provident fund. In such a fund, the employees’ contribution does not get the benefit of the tax deduction under Section 80C.

The interest earned is not taxed when it is credited. However, when the amount is received, it is separated into different parts as there are different modes of taxation depending on the source of the amount. The part that represents the employer’s contribution plus interest on it will be taxable as income from salaries. The interest on the employee’s contribution will be taxed as income from other sources, and finally, the employee’s contribution coming back will not be taxed since this was not eligible for a tax deduction earlier.

Arnav Pandya is Founder - Moneyeduschool