Tax Season Special: Provident Fund or PF and Voluntary Provident Fund or VPF

All salaried individuals have a Provident Fund (PF) .In India, employers will deduct 12% of the basic salary and put it into the individual's PF account. In most cases, there will be a full employer match. The PF account of the person is tied to the current employer. In case of a change of employer, the individual has to activate the transfer of the funds.

Investment Limits for PF
The PF contribution will be 12% of the basic salary by the individual, and a matching amount contributed by the employer. So unless your salary changes, this amount contributed will not change. In case of long periods of unemployment or leaving the country, the individual must activate withdrawal of funds from the PF account.

Investment Limits for VPF
VPF provides a way for an individual to contribute more funds into the PF which is essentially a retirement account. The individual can specify any amount (upto the entire take home salary) as the voluntary PF or VPF contribution. There will be no employer match on the VPF contribution. Of course, investment exemption can be claimed only for investing upto Rs. 1 lakh.

Lock in Period
This is an employer linked retirement fund. Upon withdrawal before the age of retirement, the interest earned will be taxable.

Return on investment
Currently the interest rate is 8.5% for both PF and VPF. Since PF contribution is mandatory for salaried individuals, I discuss advantages and disadvantages for VPF.

Advantages

• Provides an effective way (through payroll deduction) to increase the retirement kitty. This is especially useful when the basic salary is a relatively small fraction of the total take home pay.
• Interest earned is tax-free. The only other assured return instrument offering tax-free returns is PPF. VPF has a slightly higher interest rate (8.5%) compared to PPF (8%), which can add up to a significant difference over the long term.

Disadvantages

• Individuals with high risk tolerance will find the rate of returns small compared to those offered by ELSS. Smaller lock in periods offered by other instruments offer investors more flexibility in managing their money.
• After every employer change, the funds need to be transferred to the new employer. This process needs initiation, and in some cases, active follow up.

Smart Saver's Verdict
VPF can be effectively used to harness the power of compounding in your favor. If you make significant VPF contributions in the first few years of your working life, the interest on those will keep compounding. These years typically coincide with the low financial responsibility phase for most people. Subsequently, as the need for more funds arises, (such as when you need to start paying off home loans, or after you start a family), the VPF contributions can be stopped.