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Treatment of Provident Fund

Provident Fund

A Provident Fund scheme is designed to provide substantial financial benefits to employees upon their retirement. Under this scheme, a specific amount is deducted from the employee's salary as their contribution to the fund. Typically, the employer also contributes an equivalent amount to the fund from their own resources. Both the employee's and employer's contributions are invested in approved securities, and the interest earned is credited to the employee's account. Therefore, the balance in a Provident Fund account is composed of the following:

  1. Employee’s Contribution: The amount deducted from the employee's salary.
  2. Interest on Employee’s Contribution: The interest earned on the employee's contribution.
  3. Employer’s Contribution: The amount contributed by the employer.
  4. Interest on Employer’s Contribution: The interest earned on the employer's contribution.

The accumulated balance in the Provident Fund is paid out to the employee upon retirement or resignation. In the unfortunate event of the employee's death, the balance is paid to their legal heirs. The Provident Fund represents a significant source of small savings that are available to the government. As such, the Income-tax Act, 1961, provides certain deductions for savings made in a Provident Fund account.

Types of Provident Funds

1. Recognised Provident Fund (RPF)

  • A Recognised Provident Fund is one that has been approved by the Commissioner of Income-tax for the purposes of income tax. It is governed by Part A of Schedule IV of the Income-tax Act, 1961, which lays down various rules regarding:
    • Recognition of the Fund
    • Contributions by Employees and Employers
    • Treatment of Accumulated Balance
  • A fund established under the Employees’ Provident Fund and Miscellaneous Provisions Act, 1952, is also considered a Recognised Provident Fund.

2. Unrecognised Provident Fund (URPF)

  • An Unrecognised Provident Fund is a fund that has not been recognized by the Commissioner of Income-tax.

3. Statutory Provident Fund (SPF)

  • The Statutory Provident Fund is governed by the Provident Funds Act, 1925, and applies to employees of the government, railways, semi-government institutions, local bodies, universities, and recognized educational institutions.

4. Public Provident Fund (PPF)

  • The Public Provident Fund is operated under the Public Provident Fund Act, 1968. Membership is open to every individual, making it particularly suitable for self-employed individuals. However, salaried employees can also contribute to a PPF in addition to the Provident Fund operated by their employer.
  • An individual can contribute to the PPF on their own behalf or on behalf of a minor for whom they are the guardian. To qualify for a deduction under Section 80C, a minimum contribution of ₹500 per year is required. The maximum amount eligible for deduction under PPF rules is ₹1,50,000.
  • Contributions to the PPF can be made in multiple installments, each in multiples of ₹500. The contributions earn interest at a rate of 8.0%. Deposits can be made at any branch of the State Bank of India or its subsidiaries, specified branches of other banks, or at any Post Office.

Example of EPF Calculation

Let's assume an employee has a basic salary of ₹20,000 per month:

  • Employee's Contribution: 12% of ₹20,000 = ₹2,400

  • Employer's Contribution: 12% of ₹20,000 = ₹2,400

    • Out of the employer's contribution:
      • ₹733 (3.67%) goes to the EPF account.
      • ₹1,667 (8.33%) goes to the EPS account.

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Interest on EPF

The EPF account earns interest on the accumulated balance. The interest rate is declared by the government every financial year and is usually in the range of 8-9%. The interest is calculated on a monthly basis but is credited to the EPF account at the end of the financial year.

Interest Calculation

Interest on EPF is calculated based on the monthly closing balance in the EPF account. The interest rate is applied to the sum of the closing balance at the beginning of the year, the monthly contributions, and the interest earned during the year.

For example, if the interest rate is 8.5%, and the monthly closing balance is ₹1,00,000, the interest for that month would be calculated as:

[ \text{Monthly Interest} = \frac{\text{8.5%}}{12} \times 1,00,000 = ₹708.33 ]

The accumulated interest over 12 months will be credited to the account at the end of the financial year.

Tax Benefits of EPF

Exempt-Exempt-Exempt (EEE) Status

EPF enjoys a triple exemption (EEE) status under the Income Tax Act, 1961:

  1. Exemption on Contribution: The employee's contribution to the EPF account is eligible for tax deduction under Section 80C, up to a maximum of ₹1.5 lakhs per annum.
  2. Exemption on Interest Earned: The interest earned on the EPF balance is tax-free.
  3. Exemption on Withdrawal: The entire EPF balance, including the employee's contribution, employer's contribution, and interest, is tax-free at the time of withdrawal, provided the employee has completed at least 5 years of continuous service.

Conditions for Tax-Free Withdrawal

To qualify for tax-free withdrawal of EPF:

  • The employee must have completed 5 years of continuous service with one or more employers.
  • If the employee switches jobs and transfers the EPF balance to the new employer’s account, the service period with the previous employer is considered for the 5-year rule.
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