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Optimizing Taxable Income

by Tavaga Invest
Optimising taxable income

Taxes, while necessary for an economy, eats away at our disposable income. But there are judicious ways to get the right balance.

Source: Tavaga Research

When we begin earning, even before we learn to save, we learn about the taxes that whittle down the money we get to keep. However, that is where investment comes in handy. The quicker we learn about tax saving investments, the quicker we can provide for the necessary taxes.

If we earn at least Rs 5 lakh a year as salary, or as income from a business or other sources, we have to pay income tax, one of the direct taxes levied in the country. For a consultant, a tax at source is deducted by 10.3 percent. 

For those of us filing returns (applicable for anyone earning over Rs 2.5 lakh a year), Form 16 reminds us there are many answers to the question: “How do I reduce my taxable income?” 

Not knowing what are the best tax saving instruments for us results in taxes paring down our income more than the mandatory amount required by the law. The onus to invest to reduce our taxable income lies with us. Wanting to reduce our taxable income is what drives many of us to investment products, in the first place.

Tax-Free Investments

When investing to optimise our tax payments, the first question we ask ourselves is which investment is tax-free. The gamut of tax-saving investment products can be categorized as three kinds — EEE, EET, ETE — denoting the degree of tax exemptions. 

EEE or ‘Exempt Exempt Exempt’ refers to investment instruments that enjoy three exemptions — the principal amount invested, the interest incurred, and the total amount of income for withdrawal. 

These are among the best tax-saving investments because all the stages are exempted from taxes.

With EEE investments, we may claim a tax-saving deduction equal to our principal amount from our taxable income at the time of investing in the financial year of investment. Subsequently, we may claim deductions from our taxable income equal to the interest we earn on our principal invested in the following years. Finally, we may claim a deduction from our taxable income equal to the total amount we withdraw at maturity in that financial year.

Employee Provident Fund, Public Provident Fund, the New Pension System are EEE. 

EET or ‘Exempt Exempt Taxable’ are investments that have the principal and the interest earned exempted from taxation, but the income finally redeemed is taxed, according to the tax bracket we fall in.

ETE or ‘Exempt Taxable Exempt’ is a category of investment products that tax the interest, according to our tax bracket, and not the other two (principal and withdrawn income).

Fixed deposits at banks and NSCs are ETE products.

Armed with tax-saving investments, we should be clear about what constitutes our taxable income.

What is Taxable Income

Our taxable income is the income, after tax-exempt deductions, which incurs income tax, in accordance with the Income Tax Act 1961. 

The tax slabs, revised during Union budgets, are different income tax percentages applicable to different ranges of annual income. 

There are five sources of income recognized by the IT Act 1961:-

1.Income from salary 

2.Income from other sources 

3.Income from  house property 

4.Income from capital gains

5.Income from business and profession

Our gross total income is the sum of income from the sources listed above, as applicable. For the salaried, it is often the basic pay (with dearness allowance). Tax deductions owing to tax-saving investments such as tax-saving investments under 80C, tax-saving investments other than 80C, and the tax-saving options for the salaried and the self-employed are then applied to the gross income. What we are left with is our taxable income. Depending on the tax slab the income falls in, we pay the percentage amount as income tax.

Tax Brackets 

The table below shows us the tax brackets applicable today:-    

Tax slabs
Source: Tavaga Research

A new income tax regime was introduced in Budget 2020 for those individuals who were willing to give up tax exemptions and deductions. The old tax system (mentioned above) continues to exist even today as the new tax system announced in Budget 2020 was made optional.

The table below shows us the tax brackets applicable for those individuals opting for the new tax regime:

New Income Tax regime
Source: Tavaga Research

Salary Structuring

Before delving further into the tax saving sections or clauses, we should keep in mind that tax saving options for the salaried also includes salary structuring. 

A smart salary structure may help in reducing our taxable income even before we are required to file returns for the year.

Earlier there were various components, such as our contribution to EPF, medical reimbursement, HRA (house rent allowance), leave travel allowance (LTA), reimbursement of transport expenses, food coupons, and phone bill reimbursement. 

But in the Union Budget in 2018, the then-Finance Minister, Arun Jaitley, scrapped the medical and transport reimbursements. Instead, Jaitley instituted a standard deduction, a flat sum of Rs 50,000, to be subtracted from our annual gross salaries before arriving at our taxable income.

Of course, many of the key tax-saving pillars remain with us such as the 12 percent of our basic salary and dearness allowance invested in EPF and exempted up to Rs 1.5 lakh.

HRA, LTA, food coupons, car maintenance allowance, children’s education allowance, children hostel expense allowance (all of which come with stipulated limits on the amount exempted) may all be woven into our salary if we find we have expenses under these categories, to reduce our taxable income. 

The tax-exempted category of phone bill reimbursement, covering landline, mobile phone, and Internet connection expenses against bills furnished, does not have a limit and can be negotiated upon with the employer to include a reasonable (commensurate with our pay grade) amount in our gross pay for tax exemption.

Other components with tax exemptions include uniform allowance and gift voucher. 

Form 16’s Tax Saving Sections

An earning citizen will know their Form 16, the document that accompanies our yearly tax return filing. It lists out the various tax-saving sections available to those with a source of income in a given financial year (April to March), such as the popular 80C clause, as allowed by the IT Act.

Tax saving options for the salaried and the self-employed are available under 80C and other clauses, which we elaborate here.

Tax Saving Investments Under 80C and Others

The IT clause of 80C is perhaps the most well-known tax saving section. It helps with key deductions in our gross salary to reduce our tax liability.

Tax saving investments
Source: Tavaga Research

Section 80C

A deduction may be claimed on our income under 80C. An individual (or a HUF, ie.Hindu Undivided Family) is eligible for the deduction.

There are investments and expenses which are allowed for the deduction, to the tune of Rs 1.5 lakh, under 80C. 

Tax-Saving Investments Under 80C

We list some of the best tax-saving investments under 80C:-

Public Provident Fund (PPF): This is an EEE investment and is one of the best tax-saving investments under 80C. 

A PPF account is opened before we can deposit money and it acts as a fixed-income savings scheme.  A PPF account can be opened with post offices and nationalized banks. The minimum investment required for each year is Rs 500. After opening an account, partial withdrawal is allowed after five years.

PPF accounts were introduced with the objective of promoting savings and investment. The interest on PPF accounts is set by the government every quarter and is paid annually. The PPF account matures after 15 years. 

PPF deposits are EEE, which means the principal invested, the interest received and the redemption at maturity are all tax-exempt.

Sukanya Samridhi Yojna: Also known as SSY, it was launched with the objective of helping the girl child to get educated and help her realize her full potential. Under the scheme, investments are EEE.  

An SSY account may be opened with nationalized banks or post offices, for a girl child below 10 years of age, and the account’s maturity is after 21 years of opening the account or when the girl is married, after 18 years of age, whichever is earlier. However, even though the redemption is also exempted from tax, it will only be applicable if it is used for the education of the girl in whose name the account has been opened.

National Savings Certificate: NSCs are fixed income instruments which may be bought at the post office. Their term is for five years and the interest earned is compounded annually. The principal sum is tax-exempt as is the interest earned during the term of the NSCs except for the last year’s. This is an ETE investment.

Equity Linked Savings Scheme (ELSS): ELSS is a mutual fund category. Investments in ELSS are eligible for tax deductions under section 80C and have a lock-in period of three years.  Long-term capital gains taxes at 10 percent is applicable to the gains accrued through this scheme over and above Rs 1 lakh.

EPF: The Employee Provident Fund is often our primary provident umbrella, the preferred retirement savings scheme for the salaried.

Under the scheme, both the employer and the employee contribute a part of the salary to the scheme, which is managed by the Employee Provident Fund Organisation (EPFO). Under section 80C, the employee-part (12 percent of basic pay and dearness allowance) of the contribution to EPF is eligible for deduction.

Employers with more than 20 employees are required to offer EPF.

House purchase: We may also claim the purchase price, up to Rs 1.5 lakh if we purchase a house in the financial year, provided we don’t sell the property within the next five years.

Tax-Saving Investments Other than 80C

The section of 80C is not the only one allowing for tax deductions. Some of the other sections we may be familiar with from our perusal of Form 16 are:-

Section 24: This allows a deduction of the interest on a home loan we pay as EMI each year. Earlier the maximum amount was Rs 2 lakh, but it has been revised to Rs 3.5 lakh in the Union Budget 2019. This amount is over and above 80C and may substantially reduce the strain on our income which is already routed to EMI deductions.

Section 80CCD: Section 80 CCD allows a deduction for investments made in the National Pension Scheme (NPS) by us. 

The amount that is eligible for tax deduction is 10 percent of the basic salary or 10 percent of the gross total income, in case the person is self-employed. The maximum amount for deduction under this section is Rs 1.5 lakh as well.

Section 80D: Medical expenses and a steady rise in them are a reality we have to brace for. The section of 80D recognizes this necessary expense and allows exemptions. 

Under the clause, deductions are available for premium paid on medical insurance and an additional deduction is allowed for medical expenses for parents’ treatment.

The clause allows up to Rs 25,000 exemption to a taxpayer for insurance of self, spouse, and dependent children. If the person or their spouse is more than 60 years of age, the deduction available is Rs 50,000.

Within the existing limit, a deduction of up to Rs 5,000 for preventive health check-up, an expense many of choosing to make each year, is also available.

If the parents are senior citizens, then the additional exemption of Rs 50,000 is allowed on medical insurance or expenses and if the parents are less than 60 years of age, then the additional amount exempted is Rs 25,000 for medical expenses.

For uninsured super-senior citizens (above 80 years old), medical expenditure incurred up to Rs 50,000 shall be allowed as a deduction under section 80D. 

Section 80G: A deduction under this section may be claimed when we donate to specific funds or institutions which are certified under the clause, such as some NGOs and charity organizations. The maximum deduction that may be claimed under this section is Rs 2,000. 

If we choose the charity that agrees with our world-view, this could be an incentive to give back to the world as the donations made under 80G may be claimed as tax-deductions over and above the Rs 1.5 lakh allowed under the popular 80C.

Section 80TTA: Bank savings accounts incur interest which we have to report in our IT return filing as they are taxable. Under 80TTA, a maximum deduction of Rs 50,000 may be claimed on interest earned on deposits in bank savings accounts, with cooperative societies or post offices. An individual or a HUF may claim it. Again, such deductions are over and above 80C deductions. 80TTA is not applicable to interest earned on fixed-income investments.

Section 87A: The section brings some relief to those whose income is less than Rs 5 lakh but whose tax liability for the financial year is above Rs 2,000. The clause allows a rebate of up to Rs 12,500 to such individuals. 

With a judicious mix of the right expenditure heads in our salaries, 80C investments, EEE products, and the necessary expenditure under other clauses, we can arrive at the optimum way of paying our taxes by availing of the deductions allowed under the IT Act.

Tavaga is everything you need to start saving for your goals, stay on track, and achieve them in time. 

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