Taxation of Retirement Benefits: Provident Fund and Gratuity

 

Taxation of Retirement Benefits: Provident Fund and Gratuity

Retirement benefits, particularly Provident Fund (PF) and Gratuity, have specific tax implications that vary based on the employment status of the individual (government vs. non-government employees) and the nature of contributions. Below is a detailed explanation of how these benefits are taxed.

Gratuity

Government Employees:
  • For government employees, gratuity received upon retirement is completely exempt from tax, regardless of the amount received. This exemption applies under Section 10(10)(i) of the Income Tax Act.
Non-Government Employees:
  • Non-government employees are also entitled to gratuity exemptions, but these are subject to specified limits. The maximum exempt amount is calculated as follows:
    • 15 days of salary for every completed year of service, where salary includes basic pay and dearness allowance.
    • The maximum limit for exemption is capped at ₹20 lakhs as per the Payment of Gratuity Act, 1972.

Provident Fund (PF)

The taxation of Provident Fund contributions and withdrawals depends on several factors, including the type of PF account and the duration of service.Tax Exemption Criteria:
  • Continuous Service Requirement: For both government and non-government employees, PF receipts are exempt from tax if the employee has rendered continuous service for five years or more. If this condition is met, the lump sum amount received upon retirement is tax-free under Section 10(12) of the Income Tax Act
Employee Contributions:
  • The interest earned on employee contributions to a Recognized Provident Fund (EPF) remains tax-free up to a contribution limit:
    • ₹2.5 lakhs in a financial year for employees whose employer contributes to the EPF.
    • ₹5 lakhs in a financial year if there are no employer contributions
  • Any interest accrued on contributions exceeding these limits becomes taxable. Specifically:
    • For contributions above ₹2.5 lakhs, the interest on the excess amount is taxable.
    • If an employee solely contributes without employer participation, the threshold for tax-free interest rises to ₹5 lakhs

Recent Amendments

The Central Board of Direct Taxes (CBDT) introduced changes effective from April 1, 2022, as outlined in notification no. 95/2021:
  • Two separate accounts must be maintained for PF contributions:
    • Non-taxable Account: Contributions up to ₹2.5 lakhs (or ₹5 lakhs if no employer contribution).
    • Taxable Account: Contributions exceeding these limits.
The interest earned on amounts in the taxable account will be added to the individual's overall income and taxed according to their applicable income tax slab

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