The Union Budget presented on 1 February 2021 has imposed tax on interest earned on Employee Provident Fund (EPF) contributions beyond Rs 2.5 lakh per financial year. . The government has a logic for imposing this tax, as data revealed that a few HNIs were contributing a big chunk and availing of tax efficiency. However, it changes the equation for many salaried people. It includes people with salary on the higher side as well as those who contribute voluntarily through VPF. In a Voluntary Provident Fund (VPF), employees contribute voluntarily, though there is no tax benefit under section 80C of the Income tax Act (unlike contributions to EPF which qualify for tax break under Section 80C). Reason is, VPF earns the same attractive rate of interest as EPF and the interest has been tax exempt till now.
Since this new tax changes the attractiveness of EPF beyond the specified limit, let us look at whom it impacts in terms of salary level and what are the comparable alternatives. Since contribution to EPF works as a percentage of basic salary, the threshold for taxation comes to Rs 2.5 lakh divided by 12% i.e. basic salary of Rs 20.8 lakh per year. Since this is only the basic salary, the headline salary would be approximately Rs 41 lakh per year. People earning higher than this can look for comparable options for their VPF contribution. For EPF, though the new taxability is an issue, there is a matching contribution from the employer. Coming to comparison of options, the rate of interest in 2020-21 was 8.5%, which may be revised downward next year as the yield levels of fixed income investments in the market have eased. Taking a tax rate of 30%, ignoring surcharge and taking cess at 4%, the net of tax return comes to 5.8%.
While returns from VPF are attractive, liquidity is an issue. As against that, open ended mutual funds (MFs) offer liquidity in the form of easy redemptions and good credit quality as well, provided you select the right fund. There are Government Security based funds, there are funds based on State Government papers known as SDLs (State Development Loans) and funds with portfolios of AAA oriented PSUs and private sector companies. Debt MFs offer tax efficiency as well, over a holding period of 3 years or more. There is ‘indexation’ available for computation of long-term capital gains (LTCG) tax. This indexation is declared by the Government (Central Board of Direct Taxes) with reference to CPI inflation. Depending on inflation and indexation, the LTCG tax rate of 20% (plus cess) comes down significantly.
The only issue that may arise in a good-credit-quality debt MF portfolio is interest rate volatility in the financial markets. Yield levels in the secondary market, which is the underlying portfolio, move up and down and consequently the NAV of the fund would fluctuate. This volatility in a debt MF can be tackled via the following:
- Have an adequately long horizon. Over a long horizon, the accrual of the portfolio, which is the interest received on the bond and other investments in the portfolio, become strong enough to give stability to your returns;
- Prefer maturity roll-down funds. In the usual open-ended debt funds, there is a portfolio maturity that is decided by the fund manager, within the mandate of the fund. The volatility of the fund is influenced by the portfolio maturity. The longer the maturity, higher the volatility. As against the usual open-ended funds, there are certain open-ended funds where the stated policy is to let the portfolio maturity roll down. In a bond or other debt instrument, there being a defined maturity date, the remaining maturity comes down with passage of time. Roll down maturity funds behave in a similar manner. The advantage is, the market-related volatility risk comes down progressively, as the residual maturity rolls down.
For convenience of investors, some maturity roll-down funds are as follows:
- Nippon India Nivesh Lakshya Fund is a Government Security oriented fund i.e. best credit available. As on 31 Jan 2021, 97.6% of the fund corpus is invested in G-Secs and the balance in cash equivalents. The fund has a portfolio maturity of approximately 24 years and portfolio YTM of 6.68%. The portfolio yield-to-maturity is the average yield of all the instruments in the portfolio, as on a given date. Given the long portfolio maturity, this fund is suitable for a long investment horizon, say 10 years or 15 years that most PF investors have.
- Axis Dynamic Bond Fund has a portfolio maturity of approximately 9 years and portfolio YTM of 6.45%. Its portfolio comprises AAA rated corporate bonds and G-Secs. For a portfolio maturity of 9 years, an investment horizon of 5 to 9 years would be advisable.
- L&T Triple Ace Fund has a portfolio maturity of 7.3 years, portfolio YTM of 6.37% and portfolio comprises AAA rated corporate bonds and G-Secs. This would be good for a horizon of 5 to 7 years.
The SLR of investment stands for safety, liquidity and returns. EPF / VPF is safe. Debt MFs can also offer reasonable safety provided you select the fund with the right portfolio quality and do the right matching of portfolio maturity and investment horizon. Investors can manage the risks by investing in roll-down-maturity G-Sec funds (e.g. Nippon Nivesh Lakshya) or AAA oriented roll-down funds (e.g. Axis Dynamic or L&T Triple Ace). To be noted, corporate bonds are not completely free of risk, as we have seen in case of IL&FS and DHFL, which were rated AAA at one point of time but their credit rating dropped sharply later. Consequently, unless a MF is a 100% G-sec fund, some degree of credit risk remains. However, open ended debt MFs are more liquid than EPF/VPF. Those impacted by the new tax on EPF interest can do their own evaluation of the above mentioned alternatives in terms of post-tax returns.
(The writer is a corporate trainer (debt markets) and author.)