How I'm creating a baseline for my Retirement

Or how the government helps create it for me

Hi!

I use different instruments to save for retirement - stocks, equity mutual funds, debt mutual funds. These are active decisions I’ve had to make by doing my own research and transferring my money to these accounts. But there’s one instrument which is available for all employees in India - the Employee Provident Fund (EPF). Contribution is compulsory, but even if it were optional I’d still contribute for its great benefits!

Kitna deti hai?

EPFO collects the money from employees and pays interest. The interest rate for the financial year 2021-22 was 8.1%. Considering the FD rates hovering around 5% before taxes, contributing to EPF is not a bad idea.

To get returns around 8% after taxes, I would need to invest in equity or high risk debt. These carry a risk of default or underperformance and may impact my returns. EPF on the other hand has practically zero risk of default because it’s backed by the Government of India. Although it keeps changing, the interest rate for EPF is usually always at least 1-2% above fixed deposit rates.

Taxation for EPF

Contribution

Employee contributions to EPF are tax deductible up to Rs 1.5L under Section 80C.

My other investments and expenses take care of this limit already, so I don’t consider this when I’m contributing to EPF.

Interest

Interest earned for contributions to EPF up to Rs 2.5L is tax exempt. Interest for contributions above the Rs 2.5L limit is taxable. for that financial year. But once this taxation event is complete, the interest from the next year is tax exempt again.

Edit: Contributions above 2.5L are put into a taxable account, and interest generated in this account each year is considered “income from other sources” and taxable at one’s tax slab (The notification is in the comment thread below. Thanks Raj for pointing it out!). The taxation is now like an FD, which is not great, but still gives a return better than FDs available from banks.

The interest being non-taxable is very attractive to me because I don’t need to worry about taxes impacting the compounding effect in the corpus. This is a challenge with FDs and eats the gains away.

Withdrawal

After 5 years of employment, withdrawal is tax free.

This is another advantage to contribute to the EPF. Once I have a corpus enough to retire, I can withdraw this corpus and invest it to my liking without worrying about taxes.

How much I contribute to EPF

I have two options for how much I can contribute to EPF - 12% of my basic salary, or Rs 1800 a month. My employer matches this contribution and since I joined the workforce after Sept 1, 2014, all the employer contribution flows to my EPF corpus instead of EPS. So in effect, I get a 100% addition to this fund, how much ever I contribute.

Although the employer contribution is a part of my CTC, if the employer contributes directly to EPF, the money is not taxed. If I had chosen to contribute only Rs 1800, I’d get the remaining employer contribution in my salary but it would be taxed as income. At my tax slab rate of 30%, it is a no-brainer to have it in the EPF corpus.

The EPF contribution is also only 6% of my total salary (basic salary is 50% of my total salary) so socking it away for retirement doesn’t impact my quality of life much.

How EPF fits into my portfolio

Like I mentioned in my previous post, I prefer to diversify and keep a 60-40 ratio between equity and debt. I consider the EPF corpus to be a part of my debt portfolio.

One thing I take care of is that the contribution does not impact my portfolio liquidity. EPF is not the only instrument in my debt portfolio since it has a lock-in till I retire or reach an age of 58. I don’t go overboard and increase my contribution via Voluntary Provident Fund (VPF) and so on. I prefer to keep some portion of my debt portfolio liquid in the form of debt mutual funds so that I can use them in case of a large emergency which my emergency fund might not be able to cover. Liquidity is also required in case I need to increase my equity investments to maintain my 60-40 ratio.

To me EPF is a fund to be used only for retirement. The lock-in till unemployment helps (I don’t have plans to work till I’m 58) but there are options to withdraw for major life events. I don’t plan to exercise that option, and prefer to rely on the rest of my income to plan for those events.

Wrapping up

EPF is an amazing corpus building instrument, and I will continue to contribute my 12% to accelerate its compounding effect and generate that baseline for my retirement income.

Until next time!