Wealthy PF investors may opt for debt funds as Budget changes tax rule

Wealthy investors who park their spare money in voluntary provident fund (VPF) accounts may consider moving to debt mutual funds after the Union Budget’s new proposals.

Interest on provident fund (PF) was exempt from tax. The Budget proposes that interest on the PF contributions (employee contribution) above Rs 2.5 lakh per annum be taxable with from April 1, 2021.

Accordingly, the change in taxation may work against employees in higher income bracket or employees making large contribution to VPF. Assuming that basic salary is 50 per cent of the total remuneration, employees with salary of Rs 41 lakh and above per annum will be affected, reckon experts.

"Optically, the number of options for investors may appear to be many. However, when you consider parameters such as tax benefits, compounding of returns, reinvestment risk and credit risk, it whittles down to a few," said Aashwin Dugal, Co-Chief Business Officer, Nippon India Mutual Fund.

 

He said certain types of debt mutual funds offering a suitable mix of benefits such as high credit, liquidity, compounding and long term taxation on capital gains, may become attractive to such investors. 

"While investment in debt funds comes with a much higher risk, wealthy investors will have no choice but to explore this option to lower their tax burden and maximise returns," said Swarup Mohanty, chief executive officer at, Mirae Asset MF.

Currently, rate of interest on EPF/VPF is 8.5 per cent for FY19-20. Considering 30 per cent tax rate and a cess of 4 per cent, employees would get a post-tax interest of 5.8 per cent on EPF/VPF contributions (employee contribution) over Rs 2.5 lakh per annum.

The Employees' Provident Fund Organisation (EPFO) may lower the interest rates for 2020-21 at its Central Board of Trustees (CBT) meeting scheduled on March 4 from 8.5 per cent in view of higher withdrawals and lesser contribution by members during the fiscal, according to reports.

Six debt categories have given returns between 7.1 per cent and 7.6 per cent in the past year. Long-term capital gains for debt funds for a holding period of three years and above are taxed at 20 per cent with indexation.

 Since EPF/VPF investors are used to safety of capital and stable returns over long period of time, equity or real estate options are ruled out, said Dugal. Earnings on most other options such as NSC, post office and RBI bonds have become taxable. The government is not issuing any more tax-free bonds and those available in the secondary market are yielding at 4.5-5 per cent, he said.

The Union budget has proposed enabling retail investors to buy g-secs in smaller lot sizes but coupon that is paid by the bond issuer is taxable in the hands of the investors. MF schemes do not attract tax of coupon payment by the bond issuer.

"Investors could consider long duration gilt funds, especially schemes that offer the benefit of duration roll down. Which essentially means, the scheme is reducing its duration constantly by continuing to stay invested in the same security. Any incremental flows to the scheme are invested into same security. The concept is similar to hold-to maturity. We have a fund called Nivesh Lakshya Fund which broadly works on this concept," said Dugal.

 

Experts believe that with interest rates unlikely to soften further from here on, the possibility of debt funds fetching higher than 7 per cent returns in the near term looks difficult.

"Investors might gravitate towards NPS, which seems like a better long-term option despite the tax treatment at the withdrawal stage. It facilitates investments under the active or auto mode, with the former allowing investors to switch from equity to debt and debt to equity," said Prateek Pant, Co-Founder and Head of Products and Solutions, Sanctum Wealth Management.

Contributions to NPS are tax deductible up to Rs 1.5 lakh under Section 80C and up to Rs 50,000 under Section 80CCD(1B). Returns are market linked and have varied between 9-16 per cent depending on the type of funds invested in. Sixty per cent of the NPS corpus is tax-free and the remaining 40 per cent goes into buying an annuity, which is taxable.

According to reports, the top-20 HNIs had about Rs 825 crore in their PF accounts, while top-100 HNI contributors had in excess of Rs 2,000 crore.