How much tax do you have to pay on income from EPF? All scenarios explained

According to the rule change announced in the Union Budget 2021, effective from April 1, 2021, interest earned on employee contributions to EPF exceeding Rs 2.5 lakh per annum is taxable

A significant change in tax rules has impacted how interest earned on Employees' Provident Fund (EPF) contributions is treated. After Budget 2021, interest on an employee’s contribution to an EPF account above Rs 2.5 lakh during a financial year is taxable in the hands of the employee. This interest is also subject to tax deducted at source (TDS). 

EPF is a retirement scheme regulated by the EPFO (Employees Provident Fund Organisation). Any organisation or factory with 20 or more employees must be registered under EPFO; if any organisation has less than 20 employees, it can voluntarily register itself under EPFO. All employees, including regular and contractual workers whose wages are up to Rs 15,000 should be enrolled to the EPF by the organisation. The EPF amount is deducted from your salary on a monthly basis by your employer. It accumulates in your EPF account, which you can access after retirement.

"Prior to the rule change in 2021, the interest earned on contributions to the EPF was entirely tax-free. This meant that employees did not have to pay any tax on the interest income generated from their EPF balances, regardless of the amount. As per the rule change announced in the Union Budget 2021, effective from April 1, 2021, interest earned on employee contributions to EPF exceeding Rs 2.5 lakh per annum is taxable. This change was introduced to target high-income earners who were taking advantage of the tax-free status of EPF by contributing large sums to the fund," said CA Amit Bansal, Partner - Direct Tax, Singhania & Co.

Understanding the new EPF taxation rules

Previously, all interest earned on EPF contributions was tax-free. However, starting from the financial year 2021-22, the government introduced a new rule:

• Interest earned on employee contributions up to Rs 2.5 lakh in a year remains tax-free.
• Interest earned on employee contributions exceeding Rs 2.5 lakh in a year is now taxable.
• To implement this change, the EPFO (Employees' Provident Fund Organization) will maintain two separate accounts for each individual starting from FY 2021-22:

Non-taxable account: This account will hold contributions up to Rs 2.5 lakh and the interest earned on it.

Taxable account: This account will hold contributions exceeding Rs 2.5 lakh and the interest earned on it.

The interest earned on the taxable account will be added to your overall income and taxed according to your income tax slab. Additionally, Tax Deducted at Source (TDS) will be applicable if the taxable interest exceeds Rs 5,000 in a year.

Key changes:

Interest on Contributions: Previously, all interest earned on EPF contributions was tax-free. However, the 2021 rule change introduced a Rs 2.5 lakh limit. Interest earned on contributions exceeding this amount is now taxable.

Employer contributions: Interest on the employer's contribution to the EPF remains tax-free up to 12% of the employee's salary.

Calculation of taxable interest: Only the interest earned on the portion of your contributions exceeding Rs 2.5 lakh is taxable. This amount is added to your overall income and taxed according to your income tax slab.

Bansal explains with the following examples: 

• Example 1: Contribution below Rs 2.5 Lakh
• Employee's Annual Contribution: Rs 2 lakh
• Interest Rate: Assume 8% per annum
• Interest Earned: Rs 2,00,000 * 8% = Rs 16,000
• Since the contribution is below Rs 2.5 lakh, the entire interest earned of Rs 16,000 is tax-free.

Example 2: Contribution above Rs 2.5 Lakh

• Employee's Annual Contribution: Rs 4 lakh
• Interest Rate: Assume 8% per annum
• Interest Earned: Rs 4,00,000 * 8% = Rs 32,000
• The tax treatment will be as follows:
• Interest on the first Rs 2.5 lakh: Rs 2,50,000 * 8% = Rs 20,000 (Tax-free)
• Interest on the excess Rs 1.5 lakh: Rs 1,50,000 * 8% = Rs 12,000 (Taxable)
• So, Rs 20,000 is tax-free, and Rs 12,000 is taxable.

Example 3: Higher Contribution

• Employee's Annual Contribution: Rs 6 lakh
• Interest Rate: Assume 8% per annum
• Interest Earned: Rs 6,00,000 * 8% = Rs 48,000
• The tax treatment will be as follows:
• Interest on the first Rs 2.5 lakh: Rs 2,50,000 * 8% = Rs 20,000 (Tax-free)
• Interest on the excess Rs 3.5 lakh: Rs 3,50,000 * 8% = Rs 28,000 (Taxable)
• So, Rs 20,000 is tax-free, and Rs 28,000 is taxable.

Example:

If you contribute Rs 3 lakh to your EPF and the interest rate is 8%, then:

The first Rs 2.5 lakh of your contribution will earn tax-free interest of Rs 20,000.

The remaining Rs 50,000 will earn Rs 4,000 in interest, which is taxable.

• The rule change applies only to the employee's contribution, not the employer's.
• The taxable portion of the interest will be added to the individual's income and taxed as per their applicable income tax slab rate.
• The Rs 2.5 lakh limit applies per financial year.
• This change primarily affects high-income earners with substantial EPF contributions.
• The Income Tax Act, Section 194A, requires the provident fund office or EPF trust to deduct Tax Deducted at Source (TDS) on the interest earned by your Provident Fund contributions. This essentially means a portion of the interest is withheld before it reaches your account. 
•  TDS rate depends on your PAN linkage: a lower rate of 10% applies if your PAN is linked, while a higher rate of 20% is deducted if your PAN isn't linked. 
• TDS is only deducted if the total PF interest you earn in a financial year exceeds Rs 5,000 (this applies to your combined interest income from all sources).