EPF tax rolls back for now. Good time to rethink pension reform

Finance minister Arun Jaitley announced in the Lok Sabha on Tuesday that he will roll back the tax on salaried Middle India’s one true friend—the Employees’ Provident Fund (EPF). The Budget had proposed to tax 60% of the EPF corpus on retirement, leaving 40% tax-free. But if the 60% was invested in an annuity, it would remain tax-free; the tax will be paid on the income the annuity generates. The National Pension System (NPS) has retained tax-free status for 40% of its corpus. You can take 60% of your NPS corpus as a lump sum at age 60 and 40% must go to buy an annuity. Of the total NPS corpus, 40% will now be tax-free and you will pay slab rate tax on 20% of the corpus. If your NPS corpus is 100, then your tax is on 20. The annuity income is taxed at slab rate.

There has been a tactical roll-back today but clearly the pension space is up for a review—the Ministry of Finance just saw what havoc piecemeal change can cause. As a retirement corpus-targeting Indian, I would like to see several design changes in the way we are offered retirement products and choices. Allow a choice of retirement products for accumulation. My choice set should include the option to not ride a formal pension plan and do it myself. If I want to choose a pension product, I should be able to choose between the EPF, NPS, pension plans run by life insurance companies and retirement-targeting funds run by mutual funds. For a person who would rather not choose between the four, allow the default of NPS. The choice of NPS as default comes on the original structure of NPS where costs were wafer-thin and only index-linked investing was allowed. Remember that index-linked stock market investing carries much lower risk as compared to a fund run by an active fund manager who could make wrong stock calls. NPS has subsequently been opened up to active management, which will introduce higher risk and costs to the low-risk default option. Allow the default only into an index fund using NPS.

The one thing that freaks investors out is getting stuck in a product. Getting stuck with a bad decision for the rest of your life is not cool for a retirement corpus targeting 25-year-old. So, once the route has been chosen, allow windows during which a subscriber can switch from one product to the other. How many times this can happen is for pension experts to work through. Then, allow premature exit twice (or thrice—again, let the pension experts work it out) over the lifetime of the fund, but this gets taxed at slab rate to deter non-serious withdrawal. For a person losing his EMI (equated monthly instalment)-owned house due to job loss, and not being able to tap his own money in a retirement fund will be quite sad. So, allow a premature exit, but design it so that only those who really need the money withdraw.

At exit, tax all the four routes similarly. If it is an exempt, exempt, tax (EET) world, then EPF will get taxed at exit, as NPS is now, or according to a totally new formula. This also means that an equity-only eligible mutual fund will lose its zero capital gains tax status, as will the eligible product from an insurance company. Remember, that today there is zero capital gains tax on a mutual fund that invests more than 65% of its assets under management (AUM) in stocks. Life insurance corpus is also tax-free under Section 10(10D) of the Life Insurance Act.

Finally, don’t force me to buy an annuity at retirement. The annuity market offers a poor choice set today. Open it up. Allow my retirement funds a choice of an annuity, government bonds or an index fund with a dividend payment option. I’d ideally like to buy a mix of a really cheap equity index-linked products and an inflation-indexed bond with my retirement corpus.

End note: We have four products in the pure EEE pantheon in India now: EPF, Public Provident Fund (PPF), equity-linked saving scheme (ELSS) mutual fund and bundled life insurance schemes. An investment of 1.5 lakh gets a tax deduction for each of these products under section 80C, ticking the first E. EPF and PPF have tax-free interest during accumulation and the final corpus is tax-free, making them EEE. Capital gains tax are zero for mutual funds if they invest more than 65% of the corpus in direct stocks, making the ELSS corpus tax-free on redemption after a lock-in of three years, giving it the EEE status. Life insurance policies, both traditional and unit-linked, pay no tax on maturity, making them EEE, but they come with the added rule that the sum assured must be at least 10 times the premium (investment). How do these compare on returns? PPF and EPF are under an announced interest rate regime and currently give 8.7% and 8.8%, respectively. The average annual 10-year return from all ELSS products is currently 9.93%, for five years it is 11%. The average annual unit-linked insurance plan (Ulip) return over five years for a large-cap fund is 8.27%, while traditional insurance plans give annual return of less than 4%. For meaningful choice between different retirement targeting products, it will help to look at returns over the long term and then choose the right product.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com