PUBLIC PROVIDENT FUND - PPF A/C - LITTLE KNOWN FACTS - VRK100-05092009

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PUBLIC PROVIDENT FUND ACCOUNT SOME LITTLE-KNOWN FACTS

Rama Krishna Vadlamudi

MUMBAI

September 5th, 2009

Public Provident Fund account is one of the attractive avenues available for longer-term investments in India. It offers fixed, but guaranteed returns to investors. The initial period of investment is 15 years, which can be extended in periods of five years each. It offers tax benefits also. The amount invested is available as a deduction from taxable income subject to certain limits and interest earned is completely tax-free. 

Though it is a simple product, there are some little known facts about it. This article discusses them, in addition to the basic features of this investment vehicle. Even though the new Direct Taxes Code proposes some sweeping changes to the tax treatment of savings schemes wef April 1, 2011, PPF is still worth considering. PPF is a longer-term savings scheme which offers old age income security, among others, to various sections including those in the unorganised sector. 

Successive Governments have accorded a special status not only to PPF Scheme but also to several other small savings schemes. This status may continue for some more years. Through PPF, citizens are funding governments’ deficits. But, are you convinced that our money is well spent?

LITTLE NUGGETS

Extend it beyond 15 years for any number of years

Make withdrawals after 6 years and redeposit it and claim tax benefit

Interest received on PPF is completely tax-free

Open an account in the name of spouse or a child and avail tax benefit (very useful for HNIs)

Indeed, this account works wonders for subscribers after 12 or 13 years

In case of HUF, account can be opened in the name of any member of the HUF to avail the tax benefit (very useful for HNIs)

LITTLE-KNOWN FACTS EXPLAINED

EXTENSION AFTER MATURITY

PPF account matures after 15 years. The subscriber can fully withdraw the balance outstanding upon maturity. Otherwise, the account can be extended for any number of years. However, the extension has to be done in five-year block periods. Let us say, an account was opened on March 31, 1997 (FY 1996-97). The account matures by March 31, 2012 and entire amount can be withdrawn the next day, that is, April 1, 2012.

Or if the subscriber wishes, he/she can extend the account for another five years. The same can be repeated, at the option of the subscriber, for another five years after 20 years. As long as the investor desires, this process can be continued for any number of years, of course, in five-year block periods. 

For extension, there are two options for the subscriber: 1). Extension with subscription and 2). Extension without subscription. However, if the account is extended with the first option (ie, with subscription), then the account cannot be changed over to the second option (ie, without subscription) and vice versa.

1. With subscription:

In this case, the subscriber can withdraw to an extent of 60 per cent of balance that is standing to the credit at the beginning of each extended period. This can be withdrawn in one or more instalments restricted to once in a financial year. Balance outstanding will continue to earn interest. One important thing to note under this option is that this has to be informed, in writing, to the bank or Post Office where the account is maintained, failing which subscribers would not get any interest on the deposits made after the expiry during the period of extension nor can he claim any tax benefit under section 80C for the subscriptions made beyond the expiry. The information should be intimated to the PO/bank before the expiry of one year from the date of extension.

2. Without subscription:

Any amount can be withdrawn after the extension without any quantitative restrictions. However, only one withdrawal is permitted in a financial year. Balance outstanding will continue to earn interest.

WITHDRAWAL AND REINVESTMENT

As explained below, subscribers can withdraw money after six years. One of the best ways to enhance the post-tax returns from a PPF account is to use this facility. One can withdraw the eligible amount and reinvest the same in PPF account and claim deduction under section 80C. However, in order to avoid any complication from the Income Tax Officer (ITO) to such withdrawal and reinvestment, investors can use a different method. 

That is, they can first make the investment and then withdraw the sum. This way, investor need not suffer any cash flow problem – in fact, his/her cash flow would improve to the extent of tax reduction as he/she claims tax benefit for the amount reinvested.

TAX BENEFIT FOR INTEREST RECEIVED

Interest received by the subscriber is completely tax-free under section 10 of the Income Tax Act.

ACCOUNT IN SPOUSE, MINORS or HUF

Under Section 80C, the aggregate deduction is available up to a maximum of Rs one lakh only. As more than 15 instruments/payments are clubbed under this section, under which PPF also falls, nobody would be able to avail tax benefits fully under this section in a practical sense. As such, in many cases, it so happens that post-tax returns are not more than the statutory rate of 8 per cent in several cases. 

One way to overcome this negative is to explore the possibility of opening accounts in the names of minor children or spouse or a HUF; of course with their respective incomes provided investors have sufficient cash surplus to set aside. In fact, the Public Provident Fund Scheme, 1968, provides for opening of PPF account on behalf of minors, by spouse and HUF (in case of Hindus). High Net-worth Individuals (HNIs) are the major beneficiaries of these clauses.

THE MAGIC STARTS AFTER 12 OR 13 YEARS

Youngsters can start a PPF account as they start earning. In general, young people can afford high risk investments provided they do not have any other obligations. They can keep minimum deposits in the account initially for, say, eight to 10 years. Afterwards, they can increase their contribution to this account gradually. 

Mind you, your investment in the 12th year will become a three or four-year deposit as the account matures after 15 years. Likewise, your investment in 14th year will become a one or two-year deposit. The liquidity improves dramatically, after 12 or 13 years as the residual maturity of the account decreases.

Profiles of investors change over 15/25-year period. Some people will move towards higher tax bracket due to increasing incomes. On the contrary, some rich people may suffer losses and they may lose their wealth altogether. As these things cannot be known before they happen, investors would be better off sticking to their asset allocation, liquidity needs, investment objectives and diversification. 

These are the time-tested principles. PPF Scheme has served its objectives very well in the last 40 years for people who are aware of these little nuggets.

THE TIMELESS WISDOM

We need to analyse our investments based on certain basic principles, which are, Liquidity, Post-tax returns, Rate of Return, Return of capital and convenience - need not be in that order. Let us analyse the PPF account based on these basics.

POST-TAX RETURNS

Subscriptions to PPF enjoy tax benefits under section 80C of Income Tax Act. Even interest received from the account is completely tax-free in the hands of investors under section 10. The post-tax return depends on one’s tax bracket.

Tax bracket                  10%                    20%              30%

Post-tax Yield              8.92%              10.08%         11.58%

As you can see, the scheme offers a post-tax yield of 11.58% for people in the highest tax bracket which is very high among its peers

By using a combination of withdrawal facility and reinvesting the same into PPF account, investors can earn much higher post-tax returns over a period of 15 to 20 years.

YV Reddy (2001)and Rakesh Mohan (2004) committees have recommended for changes in the fixed rate of return linking it to some market rate or some other benchmark like, average yield of Government Securities. Interest rate cycle prediction is a difficult exercise. During the year 2008, depositors enjoyed interest rates as high as 11 or 12 per cent due to high interest rates. At that time, PPF account with 8 per cent guaranteed interest could appear to be less attractive. 

However, during 2004/05, we have seen bank deposit rate touching as low as 5 or 5.5 per cent. At that time, PPF account holders enjoyed better post-tax returns, even double that of the yield on bank deposits. The point is some portion of the money, depending on one’s risk profile and needs, can be set aside for long-term in PPF account.

The returns may appear to be low compared to the more-glamourous-but-riskier counterparts, like, blue-ship shares, penny stocks, mutual funds, etc. But, PPF account provides steadier and guaranteed returns.

What works well for a PPF account in the long-term is like this:

ALBERT EINSTEIN

 “The power of compounding is the Eighth Wonder of the world.”

The usual caveats here are: stable Government policy as regards to rate of return and stable tax policy and regular investments in line with risk profile and investment objective.

INVESTMENT OBJECTIVE

Different people have varied objectives while making their investments. Subscribers need to be clear about the expectations from the investment before they take decisions. As such, they have to keep in mind their needs and open PPF account only in the event of keeping the money for very longer-term.

Investors have to choose among several options depending on the purpose for which they make their investments. It’s wrong to see individual investments in isolation. People have to find suitable alternatives depending on their various needs – children’s education, emergency funds, medical costs, marriage of daughters, retirement savings and others.

RISK AND SAFETY

The product offers the lowest risk and highest safety. Return of principal and interest are fully guaranteed. Basically, citizens have been funding the Governments’ finances and fiscal deficits. As long as governments do their job properly, our money is safe. If Not? Only time will answer.

LIQUIDITY

It is very low during the initial period. On this front, PPF does not score well compared to others, like, NSC or bank deposits. Even though NSC’s duration is for six years, a loan or an overdraft of up to 75 per cent of principal and accrued interest can be availed against NSC whenever we want. The low liquidity in PPF can be overcome with the help of limited loan and withdrawal facility. 

Investors can consider withdrawal every year and can redeposit the same and avail tax benefits. PPF offers only a limited period of loan in the initial years with some quantitative restrictions. Withdrawals are allowed after six years only in a very limited way. However, the liquidity improves dramatically, after 12 or 13 years as the residual maturity of the account decreases.

CONVENIENCE

As it is enough if we make one minimum subscription in a year, subscribers need not visit the PO/bank very often. Account can be opened in more than 1.50 lakh Post Offices across the country or in more than 8,000 specified branches of State Bank of India or its six associate banks or nationalized banks. 

Account can be transferred from a Post Office to a bank branch or vice versa; or from one bank branch to another bank branch. State Bank of India offers online transfer of funds to PPF account through Internet Banking facility provided to account holders.

COMPARE WITH OTHER PRODUCTS

From liquidity point of view, NSC appears a better candidate. Employee Provident Fund which offers 8.5 per cent is more attractive than PPF. PPF account seems to have lost some of its charm in the last five to six years as investors have earned better, and in some cases excellent, returns from equity as well as debt markets in different market cycles despite huge volatility in the markets. 

However, depending on their risk and age profile, it is advisable for investors to allocate certain portion of their surplus money for risk-free schemes, like PPF, with guaranteed returns. Even though NPS has been extended to all citizens, it is yet to pick up pace. We need to see which one will be a better choice between NPS and PPF in future.

Finally, what is the BEST investment?

INVEST IN THE INSTRUMENT CALLED YOU

"What is You? It is the stuff that controls and guides the body you inhabit. It is your ultimate tool for wealth creation. It's your mind. Without it, you wouldn't have a job that gives you a salary that allows you to save and invest. It grows from the point you're born and acquire skills, knowledge (may be wisdom) over your lifetime. You do that by getting an education, then deciding your future course of life – even though that decision is largely a factor of the skills and expertise a society requires – and finally expanding that mind through experience gathered. All the while, the mind develops, learns, and expands. You monetise this effort by offering it to various employers or by going solo, either as a professional or as an entrepreneur."

GAUTAM CHIKERMANE in March 2001

OTHER BASIC FEATURES

Minimum Investment:

Rs 500 in a financial year

Maximum Investment:

Rs 70,000 in a financial year. If contributions are made beyond Rs 70,000 in any single year, interest would not be paid for the excess amount beyond Rs 70,000.

Interest It is payable at eight per cent on the last day of every financial year (yearly compounding). It is payable on the minimum balance that is available to the credit of the account on the fifth day and last day of the month. As such, we should ensure that we remit the contribution on or before 5th of every month, so that interest product will be available for the entire month. 

Suppose, you remit Rs 70,000 on the fifth day of a particular month, your contribution will be eligible to get interest for the full month; practically you are getting four days of interest freely. Interest on PPF is completely tax-free in the hands of investors (section 10 of the Income Tax Act).

Period of Investment:

PPF account matures after 15 years. After maturity, the account can be extended for any number of years in blocks of five years each.

Nomination;

This facility is available

Wealth tax:

Balances held in the account are exempt from wealth tax

Number of deposits:

Up to 12 deposits can be made in a year

No attachment:

Balance in the account cannot be attached even under any order or decree of a court in respect of any debt or liability incurred by the subscriber. In fact, businessmen who are declared insolvent for losses in their business are the biggest beneficiaries of this provision.

Loan facility Loan can be availed any time after the expiry of one year from the end of the year in which the initial subscription was made but before five years from the end of financial year in which the initial subscription was made. 

The loan availability is restricted to 25 per cent of the amount standing to the credit of the account at the end of two years immediately preceding the year in which the loan is applied for. The principal amount of the loan has to be repaid in 36 months in lump sum or in monthly instalments.

Withdrawal facility:

Withdrawal from the account can not be made during the first six years. Only one withdrawal per year is permissible thereafter (from seventh financial year). Amount of withdrawal cannot exceed 50 per cent of balance at the end of fourth year immediately preceding year of withdrawal or at the end of the preceding year, whichever is lower.

Suppose, a PPF account was opened on March 31, 1997 (1996-97). The first withdrawal from the account could be made on April 1, 2002 or during FY 2002-03. The eligible withdrawal could be lower of the two: 1). Fifty per cent of the balance to the credit of PPF account as on March 31, 1999 ; or 2). Fifty per cent of the balance as on March 31, 2002.

WHAT DOES THE FUTURE HOLD FOR THE SCHEME

Under the draft Direct Taxes Code (DTC), the Government proposes to move most of the savings instruments, including PPF, to EET (Exempt-Exempt-Taxed) method of tax treatment of savings from the present EEE (Exempt-Exempt-Exempt) method. If the EET method is implemented, then the attraction of PPF will come down. Government wants to reduce its huge interest burden on its finances in view of the fixed interest rates and tax policies in favour of investors.

The then Finance Minister, P.Chidambaram mooted the EET idea for the first time while presenting the Union Budge for 2005-06. The New Pension System (exemption under section 80CCD of IT Act) and some pension schemes (section 80CCC) are already under this EET method. 

Ultimately, we have to move towards EET. Government has been preparing the public to change their mindset. May be, it can succeed by bringing in some changes to EET system keeping in mind the interests of some deserving people. The country does not enjoy any Social Security system that is available in the US and some European countries.

We make our investments based on certain assumptions, available facts, future possibilities and comparability with competing instruments. As the product is meant for long-term, the likelihood of changes in government policy and tax policy is very high. Moreover, market structure of investments may also undergo a change with the introduction of new products. Any investment is a gradual process and we can not look back and say we had made right or wrong choices in the past. 

That is why, it is more important to look at investments in their totality. It is always better to keep investments in different baskets suitable to individual needs – liquidity, education, health, retirement, marriage, etc. I envisage three scenarios for the PPF Scheme, 1968 in terms of the provisions contained in the draft Direct Taxes Code (DTC):

1. Due to political expediency, the Government will not be able to implement the EET method for the PPF even after the introduction of new Direct Taxes Code from April 1, 2011.

Action required: Nothing

2. The Government persuades the stakeholders and decides to implement the EET system for PPF from April 1, 2011 onwards and benchmarks the interest rate on PPF to the average yield on Government Securities as suggested by YV Reddy and Rakesh Mohan Committees some years back.

Action required: Accountholders can continue their investments regularly till March 31, 2011. The Government in the draft DTC has stated that the tax benefits under the present EEE system will continue for the balances available as on March 31, 2011 (grandfathering clause). In fact, I foresee a funny situation where subscribers will rush to deposit the maximum permissible amount Rs 70,000 in their accounts to avail the benefit of this grandfathering clause before March 31, 2011! For continuing the existing accounts beyond March 31, 2011, the Government will definitely find a new system for the benefit of accountholders.

3. The Government, as some sort of a via media, may continue with the present tax benefits while linking the interest rate on PPF to the average yield on Government Securities.

Action required: Investors can continue their investments in PPF as it is and review their decision once the amendments are made known to the public by the Government.

HOW SHOULD YOU POSITION YOUR PPF A/C FROM NOW

If you ask me what the likely scenario is, I would put my bets on the third scenario. But, one cannot be too sure about Government’s policies in the long run. To sum up, my feeling is that subscribers need not worry about the proposed changes in the EET method of tax treatment of PPF as per the new DTC. They can continue with their investments in the PPF account normally. 

For long, successive Governments have accorded a special status, not only to PPF account but also to other small savings instruments. As such, they would find it extremely difficult to bring about any radical changes in these schemes. But, investors need to watch the developments on this front closely and more actively. Or, do you foresee some sort of a Black Swan event here?

Sources: PPF Act, PPF Rules, websites. Disclaimer: This article is meant for general reading and investors need to consult their qualified financial advisors before making any investment decisions or for tax implications.

Please see the following RBI circular dated 17 June 2011 for amendments to PPF account:

https://www.rbi.org.in/commonman/English/scripts/Notification.aspx?Id=949

Extension of PPF Account after 15 years:

PPF account can be extended for any number of block periods of five years each, after the completion of first 15 years. This information is provided by National Savings Institute, a Government of India agency. Please see the link here: http://www.nsiindia.gov.in/InternalPage.aspx?Id_Pk=79