Watch out, salaried! Interest on PF after you quit working is taxable

In India, Provident Fund (PF) account is considered to be the backbone of lifetime savings by most employees. In the absence of a dependable pension system in the country, the PF serves as a contingency reserve for many people in the working class. Due to ongoing monthly mandatory contributions (12% of salary each by employee and employer), which goes into the PF kitty during the working life, it often leaves the employee with reasonable funds for their twilight years.
Apart from the fact that PF serves as an automatic retirement savings, employees generally choose to maintain their PF account, because of the following tax-related benefits (subject to fulfilment of certain conditions):
# Annual deduction from taxable income for employees contributions to PF (up to Rs 1,50,000 at present).
# Exemption from tax for employer’s contributions to PF.
# Tax exempt market-linked rate of interest on the balance in PF account (unlike many other debt investments which are taxable).
As this tax-free interest is credited into the employee’s account on an annual basis, the compounding effect usually results in accumulation of a sizable corpus by the retirement age.
Once an individual completes 5 years of contributory service with one or more employers (after having transferred the PF balance in the account with one employer), the entire resultant corpus accumulated over the working years is also allowed to go tax-free.
However, the Bangalore bench of the Income-Tax Appellate Tribunal (ITAT) has recently ruled that PF interest earned after the date of cessation of employment of the employee is taxable, even if the condition of 5 years’ contributory service is satisfied.
In this case before the ITAT, the individual had retired after serving 26 years in April 2002, but chose not to withdraw his PF balance on retirement. As on the date of retirement, the PF balance was approximately Rs 38 lakh, which grew to approximately Rs 82 lakh due to the annual interest credited to the PF account. The individual withdrew the entire balance in his PF account in April 2011, i.e., 9 years after he retired and left his employment/ stopped PF contributions.
The ITAT agreed with the view of the tax officer that the interest after resignation date is taxable. The same is on the basis that the tax exemption is available only for ‘accumulated balance’, which is defined to mean the balance standing to the credit of the employee in the fund on the date of his ceasing to be an employee.
As can be seen, individuals who choose to let the Provident Fund balance remain in the same account post-employment termination (resignation or otherwise), under the impression of earning tax-free interest corpus, may be in for a rude shock.
As per the amended PF rules, a PF account will become inoperative and not be eligible for interest after 36 months from the date the individual migrates abroad permanently or the date of retirement after attaining the age of 55 years. In other words, individuals who retire/ resign before 55 years would be eligible to earn interest but only up to 58 years of age.
Assuming the PF interest rate to be 8.6 per cent per annum, post tax (assuming the highest tax rate of 30% plus applicable surcharge/ cess), the effective interest yield would be around 6 per cent. In case employee chooses to leave the balance with the fund, the interest accrued and credited to the account each year should be offered to tax depending upon the cash or accrual reporting basis adopted by him for interest income.
Therefore, from a financial planning perspective, an employee should now consider this tax impact while deciding whether to withdraw the Provident Fund balance and invest the funds in other avenues or leave it with the fund to accumulate further interest.

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