Arun Jaitley’s third budget had little to offer for the salaried middle class in particular and the middle class in general. But there was a huge negative point which perhaps no one saw coming.
The Employees Provident Fund(EPF) and other recognised provident funds are a huge mode of saving for the salaried middle class. Up until now the EPF worked on exempt-exempt-exempt or the EEE principle. The money invested in this investment is tax free, the interest earned is tax free and so is the corpus earned on maturity.
What does this mean? As Sandeep Shanbhag, Director, Wonderland Consultants, a tax and investment advisory explains: “In EEE tax saving effected is permanent in nature. This means that once the tax is saved for that particular year, it is saved, per se. When the invested amount matures, it is tax-free.”
Nevertheless, Jaitley has proposed to bring EPF and other recognised provident funds under the exempt-exempt-tax or the EET principle. As Jaitley said during his budget speech: “I propose to make withdrawal up to 40% of the corpus at the time of retirement tax exempt in the case of National Pension Scheme.
In case of superannuation funds and recognized provident funds, including EPF, the same norm of 40% of corpus to be tax free will apply in respect of corpus created out of contributions made after 1.4.2016.”
Before getting into the details of what Jaitley means by this, let’s first try and understand what EET means. As Shanbhag puts it: “When the EET system is put into place, permanent tax saving won’t be possible. This is because, by making an investment, you will reduce the same from your income thereby lowering the tax liability. However, when the amount matures, it would be taxable in that year.”
This essentially means that under the EET system, the money invested in EPF and other recognised provident will be tax-free, the interest earned will be tax-free, but the accumulated corpus will be taxed. Hence, as Shanbhag puts it: “Therefore, this is a deferment of tax and not saving of tax. In other words, you will defer (postpone) the payment of tax depending upon the lock-in of your tax saving investment. However, some time or the other, the investment will mature. At that time, tax will be levied.”
Let’s try and understand this through an example. Let’s say you invest Rs 50,000 every year into EPF, starting from April 1, 2016.
The amount invested can be deducted while calculating the taxable income. Every year the interest earned on this would be tax free. Let’s at the end of 20 years, you earn an average return of around 8.7% per year. This means you would have accumulated around Rs 24.73 lakh. Under the EEE principle this amount is totally tax-free.
Under the EET principle this amount will be taxable. How much tax will you have to pay? Jaitley said during his speech that 40% of the corpus will be tax free.
This means 40% of Rs 24.73 lakh or Rs 9.89 lakh will be tax free. Tax will have to be paid on the remaining Rs 14.84 lakh, if this amount is withdrawn. This amount will be taxed according to the prevailing income tax laws at that point of time.
The question everyone is asking is, why is Jaitley or actually the government doing this? A few years back, the government launched the new pension scheme (NPS). This scheme follows the EET principle.
Up until now, 40% of the maturity corpus of NPS had to be compulsorily used to buy immediate annuities. These are essentially insurance policies which help earn a regular income. The remaining 60% of the corpus could be withdrawn. Nevertheless, an income tax needs to be paid on it.
Jaitley in his budget essentially removed this prevailing discrepancy between NPS at one end and EPF and recognised provident funds, on the other. Now on, 40% of the maturity corpus of the investments made on or after April 1, 2016, can be withdrawn and no tax needs to be paid on it. The remaining 60% will be taxed if you withdraw the amount. The same principle applies for other recognised provident funds as well.
Further, if you use 60% of the money to buy immediate annuities, to generate a regular income, you don’t have to pay any tax on it. Even with this, this is a very anti-salaried/middle class move. This is primarily because of the fact that people use their provident funds to get their children educated as well as married.
They even use it to buy a home after retirement. If they want to do something along these lines, they will have to withdraw money and pay income tax on it.
Also, at the end of the day, it is also about letting the individual decide what he wants to do with her or her money. The immediate annuities currently available in the market do not generate returns which are comparable to other investment avenues like simply investing the money in a fixed deposit or buying tax free bonds, for that matter. Hence, to that extent this is a sub-optimal solution for those who know what to do with their money.
Further, why has Jaitley and indeed the government left out maturing amounts paid on insurance policies and tax saving mutual funds, is a question worth asking. These investment avenues continue to follow the EEE principle. Why is there this discrimination?
If Jaitley and the government do not withdraw this change, all it will do is empower the insurance agents of Life Insurance Corporation and private insurance companies to start another sound of mis-selling to the citizens of this country. And that is not a good thing.
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)
The column originally appeared on Huffington Post India on February 29, 2016