The tax blow delivered to subscribers of the employees’ provident fund (EPF) - that 60 percent of the withdrawal proceeds may be subject to tax (unless all of it is invested in purchasing annuities) - may be cushioned somewhat when the finance minister replies to the budget debate, but subscribers should henceforth be on guard. Once governments get the idea that some lumpsum receipts can be taxed, they will find a way to do so. Tomorrow if not today.
This article intends to take the position that citizens will henceforth be better off managing their own retirement corpuses instead of relying on the automatic deductions made through the EPF, or even the voluntary contributions made to the National Pension Scheme (NPS). The NPS is better designed, and gives you more options, but since the money is tied to government-imposed conditionalities on withdrawal and taxation, there is no guarantee that the tax regime will be the same when you retire and need the money to run your life. (Read here and here)
The point one would like to make is that both EPF and NPS are sold as benevolent tax-efficient products to the citizen, but this is – at best – a half-truth, if not an outright con-job. The government wants you to believe that it is giving you a tax-break under section 80C on your EPF contributions, and hence it is entitled to tax you for this favour when you retire.
But is this really true? The money you invest in EPF actually goes into government paper, where yields are typically lower than in fixed deposits. So, it is government that benefits by getting access to your EPF money.
Nor are the tax benefits all that great. For example, EPF contributions made by those who earn up to Rs 2.5 lakh per annum get no additional tax cut since you are anyway in the tax-exempt income bracket. For those earning above Rs 15 lakh per annum, the EPF contribution benefit comes only for contributions up to Rs 1.5 lakh per annum – that is, monthly contributions of up to Rs 12,500. For contributions above this level, you do not get 80C benefits, though your employer’s contribution does get him a deduction.
Put another way, the real tax benefit for EPF contributors comes when your contributions go up to the level of Rs 12,500 per month. After that, all EPF contributions are tax-paid.
In the case of NPS, since this contribution is usually over and above the EPF payment, much of its may be tax-paid.
So it is not right to say that the government is doing any large-scale favours to taxpayers on either EPF or NPS, except for the fact that the incomes earned are not taxed – this is the middle ‘E’ in the Exempt-Exempt-Exempt tax formulation on EPF formulations. But the first ‘E’ is only partial, and the last ‘E’ has now become taxable on withdrawals (the annuity incomes are anyway taxable at your bracket).
However, the real issue is not this. It is that you do not get the tax breaks you would ordinarily get if you were not part of these schemes at all.
Three tax benefits you don’t get by being part of EPF and NPS are the long-term capital gains tax (zero tax after one year) on equity investments, the cost indexation benefits for debt investments (and lower tax rate of 20 percent plus cess); and the purchase of tax-free bonds.
On an average, EPF has given returns of around 8.5-8.75 percent annually, and NPS around 7.5-12 percent (depending on which part of the scheme you are evaluating, since your money is split into equity, bond and government securities investments, and what you get is the hybrid return, which can vary from year to year, fund manager to fund manager).
But this is all pre-tax, which means at the top bracket you have to lose more than 30 percent of these returns. Arun Jaitley is waiting to pick your pocket.
As opposed to this, debt and liquid funds have returned 8-9.5 percent in the recent past and equity schemes more than 25 percent over the last three years. Over longer periods, equity schemes give you compounded returns of at least 10-12 percent, and index funds have given around 9.5 percent in the last three years. And remember, equity-linked savings schemes (ELSS) get the same tax benefit under 80C as your EPF or NPS contributions.
But here’s the kicker: on equity schemes you pay zero tax and get higher returns. On debt schemes, you get to index your costs to inflation and pay lower tax, and if you assume average inflation of 4-5 percent, the incomes that will be taxed will be much lower.
Even better, you get flexibility. You can change your investment pattern over your lifetime by investing in the right mix of equity or debt at appropriate times.
Now consider some hypothetical numbers. Let’s assume you invest Rs 1.5 lakh every year in ELSS schemes from age 25. At the time you retire at, say, age 60, assuming a conservative 10 percent annual compounding rate, your corpus would be Rs 4.4 crore – and all tax-free. EPF would give you a gross amount of around Rs 3.1 crore pre-tax, assuming the current rate of around 8.5 percent in maintained. But you would lose a lot of it in taxes on maturity.
Or take debt. If you were to invest the same amount in debt, at an assumed annual yield of, say, 8 percent, the same Rs 1.5 lakh invested every year over 35 years would fetch you just under Rs 2.8 crore (pre-tax), but you would get inflation adjustment. This means, even though you get less than EPF, your actual tax will be lower, giving you higher returns. But good debt funds may actually get you more than the EPF rate. So chill.
And don’t forget, you also have the option to invest in tax-free bonds, which currently offer 7-7.3 percent yields to maturity on 10- and 15-year tenures.
Quite clearly, a judicious mix of ELSS, non-ELSS equity funds, index funds, debt funds and tax-free bonds will beat the EPF and NPS hands down.
The best part of it is your money is in your own hands, and you can change the allocation patterns tax-efficiently by consulting a personal finance advisor. Tax-free switches from equity to debt can be made during bull markets and switchbacks to equity made during bear markets.
Of course, this needs you to be willing to take more interest in how your money is faring, but it is a darn sight better than not knowing how the government will tax you when you retire thinking you have it made. Jaitley may back off this time, but some future FM may be hard-nosed enough to tax you to the gills.
Your takeout from the above: It is time to ditch both EPF and NPS to the extent the law will allow you.
For a government that claims EPF is some kind of favour to the rich, the least it can do is let people opt out.