Article

How Does the Employee Provident Fund (EPF) Work?
June 07 , 2012

The Employee Provident Fund (EPF) or simply Provident Fund (PF) is a long-term savings and pension instrument for all salaried persons in India. Any organisation having over 10 employees is required to register with the Employee Provident Fund Organisation (EPFO).

For all employees in such an organisation who draw a basic monthly salary of Rs 6,500 or less, the PF is mandatory. For all others, the PF is optional - such employees can opt out of the PF at his discretion. We at Fintotal however recommend all employees to avail of the PF, since it's a great long-term savings instrument. It returns are high, tax-free and safe; and its lock-in fights our propensity to spend the money away.

Contribution to Employee Provident Fund

You as an employee contribute 12% of your Basic Pay towards your PF every month. This is typically deducted from your salary before being credited into your Bank. Your employer pays 12% of your basic and adds it to your account. That makes it 24% of your Basic Pay. In addition the employer contributes to 1.61% towards charges an insurance scheme as explained below.

Not all the contribution goes to PF. Part of it goes towards administration charges (1.11% in all). Another part goes to the Employee Deposit Linked Insurance Scheme or EDLIS (0.5%). A portion goes to an Employee Pension Scheme or EPS (8.33%). The remaining (15.67%) goes to the PF itself.

If your basic pay comes to Rs 20,000 here is what the typical breakup of EPF contributions will look like

Contribution

Calculation

Amount (in Rs)

Your share

20,000x12%

2,400

Employer's share in EPF

20,000x3.67%

734

Employer's share in EDLIS

20,000x0.5%

100

Employer's share in EPS

20,000x8.33%

1,666

Administration charges (Employer's share)

20,000x1.11%

222

Who manages provident funds?

Some organisations manage their own PF and register this with Income Tax and the Labour Ministry. Others use the services of the EPFO to manage their fund. In either case, the returns to you as an employee remain the same.

The PF currently is allowed to invest only in debt- such as government bonds. It is not allowed to invest in equity, though there have been some demands to allow it to invest a small portion here. The interest that the PF pays is independent of the performance of the fund, and is fixed by the Board of Trustees that manage the PF. The current interest rate it pays is 8.5% (tax-free).

The EPS is separately managed, and is used to provide life pension to the individual and spouse after retirement.

The EDLIS goes to pay life insurance to the family members of the PF member in case of her death during employment. The EDLIS has a maximum payout of Rs.1 lakh, and is equal to the average balance in the PF account in the last 12 months. This is paid back over and above the return of the PF itself.

Taxation of Provident Fund

Your contribution to a Recognised Provident Fund has deduction under section 80C up to the limit of Rs 1 lakh. Rs 1 lakh is the overall cap for all deductions made under this section.

Company's contribution up to 12% of salary is tax exempt. No income tax is to be paid on it. Any contribution above that is taxable. The Fourth Schedule of the I-T Act deals with these rules. For government employees entire contribution of employer is tax exempt.

Interest up to the limit allowed by the government is exempt from tax. This rate sometimes varies. In 2013-14 it is 8.5%.

On EPF withdrawal taxation depends on how many years you completed service. If you have completed 5 years of total service (with all employers put together) then the entire amount is tax free. If 5 years have not been completed before withdrawal then 80C EPF deductions claimed will be reversed and added to 'salary income', as well as accumulated amount from your company's contributions and interest will be added to your salary. TDS will apply on the PF withdrawal amount. The 5 year clause does not apply for if you are withdrawing for reasons beyond your control like illness, shut down of business, etc.

For government employees entire PF withdrawal is tax free any time.

In case your company has an unrecognized provident fund (usually only if there are less than 20 employees) then employer's contribution and interest on it will be taxable in the year of withdrawal. Interest on your contribution will be taxable annually as 'income from other sources'. Your own contribution will not be taxed on withdrawal and note that your contribution to Unrecognized PF will not get 80C benefit.

How to withdraw from provident fund?

You can fully withdraw your PF once you attain 55 years of age. You can also withdraw it earlier if you are out of a job for over six months. However, in such a case, if you have had the PF for less than five years, the PF becomes taxable.

In the interim years, you are allowed to borrow from your PF for a variety of uses such as house construction, children's education, treatment of illness, injury or handicap, etc. You may contact your Finance department in case of such special needs. Of course, given that PF is primarily a retirement corpus, we would strongly advise against utilising PF money for other assets or expenses- remember, its your own money you are eating away!

The Employee Pension Scheme can be used after retirement to draw a monthly pension. This is also payable to the widow after the death of the individual. Up to 1/3rd of the corpus in the EPS can be commuted (i.e. withdrawn immediately) and the rest needs to be compulsory taken as a pension. The valuation of the EPS and pension amounts are complicated and we will not go into them here. But suffice it to know that this is a safe and risk-free basic pension. Of course, it is unlikely to be enough in itself, especially compared to inflation. Thus, separate pension planning needs to be done. But this is a good starting point.

Summary

In summary, the PF and the associated pension schemes are useful tools given by the Government to facilitate retirement planning. All employees can use these schemes as a starting point. However, in themselves, they are unlikely to be adequate to cover all retirement and pension needs, especially with our exploding prices and lifestyles. Thus, retirement needs to be planned separately (in addition to the PF) too.

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