ET Wealth | Should you stop VPF?

Till a month ago, Nitin Aggarwal had no reason to alter the simple investment strategy he has followed for years. The Hyderabad based IT professional puts Rs 20,000 in equity funds and pours Rs 45,000 into the Voluntary Provident Fund (VPF) every month. “The VPF gives me 8.5% tax free returns, the highest for any fixed income instrument,” he says. However, the Budget proposal to tax the interest earned by contributions exceeding Rs 2.5 lakh a year could change this simple structure. Along with the mandatory contribution of Rs8,500, Aggarwal’s total monthly contribution to the Provident Fund is Rs 53,500, or Rs 6.42 lakh in a year. From April, the interest earned by Rs 3.92 lakh will get taxed, reducing Aggarwal’s returns to 5.85%. Since Rs 2.5 lakh contributed by him will still earn 8.5% tax free returns, his overall return from the Provident Fund will fall to 6.9%. “I am exploring other options that can give me better returns than 5.85%,” he says.His concern is shared by millions of Provident Fund subscribers. Only a small percentage of EPF subscribers have salaries high enough that their mandatory contribution breaches the annual threshold of Rs 2.5 lakh. But a large number of subscribers put more than the mandatory 12% of basic in this tax-free haven. An online survey conducted by ET Wealth shows that one out of two subscribers use the VPF to invest more than the mandatory amount in the Provident Fund. Also, over 51% of the 3,578 respondents contribute more than Rs 2.5 lakh a year and will, therefore, get impacted by the new tax that is proposed to kick in from April.The tax will impact middle and high income PF subscribersOne out of two respondents contributes more than the mandatory 12% of basic pay to Provident Fund. 81240501A caveat: online surveys are skewed towards middle and high income groups and leave out a large section of blue-collar workers who form the biggest chunk of subscribers to the Provident Fund. So, our survey represents the opinions of EPF subscribers from the middle and upper income groups.Many subscribers would reconsider investing in VPF now 81240529The findings support the Finance Ministry assertion that high salaried subscribers are pouring in large amounts into the tax-free haven. The figures are mind boggling. According to one news report, the 20 biggest subscribers have stashed away Rs 825 crore in their Provident Fund accounts. The largest account has more than Rs 100 crore, which means it is earning more than Rs 8.5 crore tax-free interest every year. That’s more than Rs 70 lakh tax-free interest earned every month. 81240537Two other accounts have more than Rs 85 crore each, which earns them over Rs 7.2 crore tax-free interest every year. Assuming these three individuals are in the Rs 5 crore income slab where the effective tax rate is 42.7% after the 37% surcharge, the government loses more than Rs 10 crore in tax on the Provident Fund interest that accrues to them every year. 81240546By putting a Rs 2.5 lakh cap on the contribution that will earn tax-free interest, the Budget has effectively brought down the shutters on this tax-free haven. It is a clever move, because it affects only the creamy layer of the salaried class.The respondents to our survey are across income levels, with less than 5% earning over Rs 1 crore a year and a little over 12% earning between Rs 50 lakh and Rs 1 crore. Even so, a significant 7% of the respondents put in more than Rs 12 lakh a year in the Provident Fund, with a tiny minority (2.8%) putting in more than Rs 24 lakh. Game over for VPF?Like Aggarwal, many contributors to the VPF are now exploring other options that can give them higher returns. Almost 74% of respondents to our survey say they will restrict their Provident Fund contribution to Rs 2.5 lakh a year and invest the remaining in some other investment option. That’s because the interest on the Provident Fund contributions above the threshold will be treated as income and taxed at the marginal rate applicable to the individual. In the 20% tax bracket (income between Rs 5 lakh and Rs 10 lakh), the returns will fall slightly to 6.7%. But in the 30% tax bracket, they will fall to 5.85%. For those in higher income brackets, the returns will be even lower. Those in the C-suite drawing more than Rs 5 crore a year will earn only 4.87% on their Provident Fund. 81240554Is this the end of the road for the VPF? Not really. Experts believe that though the new tax will pare the returns, the VPF still works out to be the best investment option in the fixed income space. “Other fixed income options such as bank deposits and bonds are offering 6-6.5%. Their post-tax returns are not comparable with what VPF will give,” says Archit Gupta, CEO of tax filing portal Cleartax.com. The RBI Savings Bonds launched last year are offering 7.15% but the interest is fully taxable. Investors should focus on the small savings schemes that are still tax free. “VPF investors who don’t have a PPF account should open one immediately. If one has a daughter below 10 years, one can go for the Sukanya scheme,” says Gaurav Garg, Head of Research, Capital Via Global Research. 81240571Some analysts believe that the new tax will make subscribers shift from the Provident Fund to market-linked or equity-based instruments. This may not happen, because someone who contributes a large amount to the Provident Fund generally has a low risk appetite. The perception of risk is not likely to change just because returns have come down. The biggest draw for the 26% respondents who want to continue with the VPF is the safety of their money, followed by the high post-tax returns and assured returns (see graphic). 81240576Even so, individuals should consider other saving options such as the NPS. “VPF investors should reduce the self contribution to the Provident Fund to Rs 2.5 lakh and invest the rest in NPS where they can claim additional tax deduction and potentially earn higher returns,” says Sudhir Kaushik, Co-founder of tax filing portal Taxspanner.com. Indeed, the tax benefits offered by the NPS can boost the returns for investors. “Instead of investing Rs 50,000 in the VPF, if the same money is put in the NPS, an investor can lower his tax by Rs 10,000-15,000,” says Kaushik.In the higher reaches of the income pyramid, where surcharges push up the effective tax rate to up to 42.7%, the returns from the Provident Fund contributions will fall to below 5%. For such individuals, the NPS benefit under Sec 80CCD(2) can be especially very bountiful. Under this section, up to 10% of basic pay put in the NPS by the employer is tax free. But as our survey shows, more than 72% of the respondents willing to explore such an option have already opted for this.Not many VPF investors are comfortable with NPS because it is a market linked product and the income is not entirely tax free. While 60% of the corpus is tax free on maturity, the remaining 40% has to be put in an annuity to earn a monthly pension that is fully taxable. VPF investors, on the other hand, are used to guaranteed returns and want tax-free income.With the VPF now losing its tax-free status, life insurance companies may see this as an opportunity to hawk guaranteed income plans. The returns of these plans are low but there are other benefits. There is no limit to how much you can invest and the income is fully tax free under Sec 10(10d) if the life cover is at least 10 times the annual premium. Also, unlike the Provident Fund rate which could come down in later years, the maturity corpus guaranteed under an insurance plan will not change.Some investors in the very high income groups, where the post-tax return from VPF is below 5%, may find these plans worthwhile. But keep in mind that an insurance plan is a multi-year commitment and will need to be continued for the full term. Stopping midway could lead to lapsation of policy or slapping of surrender charges.Another possible alternative to the VPF can be debt funds. If held for more than three years, the gains from debt fund investments are treated as long-term capital gains and taxed at 20% after indexation. Indexation takes into account the inflation during the holding period and accordingly adjusts the acquisition price upwards which lowers the tax. But bond yields have come down quite sharply in the past 1-2 years and may not move down from here. The yield to maturity of most debt funds is now close to 5-6%. This means a prolonged period of low returns for investors. If a fund delivered 6.5% compounded growth over three years and inflation was 5% per year, the post-tax return would be around 6.2%.Recent developments in the debt fund space has also dented the confidence of investors. Investors who are comfortable with some risk can venture into conservative hybrid funds that invest a small 10-15% of their corpus in equities to earn higher returns. But not many VPF investors would take that route.

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