The presence and absence of RNA modifications regulates RNA metabolism by modulating the binding of writer, reader, and eraser proteins. For 5-methylcytosine (m5C) however, it is largely unknown how it recruits or repels RNA-binding proteins. Here, we decipher the consequences of m5C deposition into the abundant non-coding vault RNA VTRNA1.1. Methylation of cytosine 69 in VTRNA1.1 occurs frequently in human cells, is exclusively mediated by NSUN2, and determines the processing of VTRNA1.1 into small-vault RNAs (svRNAs). We identify the serine/arginine rich splicing factor 2 (SRSF2) as a novel VTRNA1.1-binding protein that counteracts VTRNA1.1 processing by binding the non-methylated form with higher affinity. Both NSUN2 and SRSF2 orchestrate the production of distinct svRNAs. Finally, we discover a functional role of svRNAs in regulating the epidermal differentiation programme. Thus, our data reveal a direct role for m5C in the processing of VTRNA1.1 that involves SRSF2 and is crucial for efficient cellular differentiation.