It’s that time of the year when the accounts department or the HR starts sending mails or call for proof of annual tax savings. Such calls and messages typically make taxpayers wince at the thought of yet again paying their hard earned money as tax to the government towards nation building. Taxpayers are an endangered species – in a nation of over 125 crore people, there are about 2.79 crore who file their income tax returns, which turns out to less than 2.5 per cent of the population. So, if you ever feel sad about paying income tax, think again; because you comprise of the very few who actually contribute to the government’s revenues.
Nevertheless, most taxpayers do not treat their contribution seriously. Tax planning is seen more as a chore than a method to save taxes, which could also be aligned with your personal financial goals. Tax planning involves sensible utilisation of the various sources of your income and investments to extract the most from them. However, most taxpayers land up complicating their tax savings options because they think tax planning is difficult. If you prepare to tackle it methodically, it could become an easy affair.
For instance, you will realise that by aligning many of your financial goals, including essential costs on your child’s education and repayment of home loan, you will not only optimise your tax outgo but will also be closer to achieving your financial goals. If you are wondering why we are laying so much stress on income tax planning, it is because the tax rates does not discriminate taxpayers whether they earn Rs 5 lakh a month or Rs 5 lakh in a year. The savings options available to both the category of taxpayers are the same.
As is the case with each financial year, this year also has a few changes that one needs to keep track of. The lowest tax rate of income tax has been reduced by half to 5 per cent instead of 10 per cent and taxpayers at the 5 per cent tax bracket will be subject to easy tax filing with a single page tax filing form. In similar vein, to discourage the practice of raising false house rent allowance (HRA) claims in case of payment of house rent exceeding Rs 50,000 a month has to be accompanied by a 5 per cent tax deduction at source (TDS). This has been done to create a trail when TDS is deducted for the tax department to track the recipient.
Further, the role of cash has diminished in our lives post demonetisation in 2016, which means a lot of money, will be resting in bank and other alternates to bank savings. But, considering the poor returns on interest that bank savings earn, smart people will opt for tax efficient alternates such as liquid funds, which are a type of mutual fund, in which you can park the surplus for tax efficient gains compared to bank savings. Today, several Mutual Fund Companies have taken advantage of the digital medium, which makes transferring money from your bank account to these types of funds a matter of tapping a few fingers.
5% The lowest tax rate for annual income between Rs 2.5 lakh to Rs 5 lakh
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Sifting Tax Savings
For taxpayers, there are several tax-saving opportunities that exist from standard deduction towards house rent allowance (HRA) and travel expenses by way of conveyance allowance to medical reimbursements. However, the bulk of action is visible within the ubiquitous Section 80C under which you can save and invest money to claim income tax deductions (See: Tax Savings under Section 80C). Broadly, within the range of various tax- savings options under Section 80C, the ones that are tilted towards savings and investments can be divided into those that have market-linked returns and those that have fixed returns.
Then there are several other heads under which one can claim tax savings (See: The Various Tax Savings Options). However, do not be blinded be the available tax savings options to put your money into financial instruments to simply save tax; instead use the window available to match your financial goals or needs with available income tax saving options. For instance, take life insurance to protect the financial interests of your dependents than to simply save on taxes. Likewise, don’t go for a home loan because there is tax savings on repayment of both the interest and principal component of the home loan. Take a home loan if you need one and as much as is comfortable for you to repay it.
Smart taxpayers will tell you that they get the most of their tax saving because they do not focus on tax planning as an activity in isolation. They treat tax planning as an essential part of their financial planning, because efficient tax planning enables them to reduce their tax liability, even as they match their life’s financial goals with available tax saving options. All of this is done legitimately and is in no way evading income tax by taking advantage of all tax exemptions, deductions, rebates and allowances while ensuring that their investments are in line with their long- term financial goals.
Step by Step
The first step towards optimising your taxes is to list out the essentials that you have to meet; for instance, there is little that you can do to your provident fund contributions as a salaried taxpayer. With the quantum of tax savings under Section 80C limited to Rs 1.5 lakh in a financial year, you should deduct the annual PF contribution from Rs 1.5 lakh to know how much more you can deploy towards tax savings. If you are servicing a home loan, prioritise to claim the most towards this financial commitment. And, if you have children who are studying, utilise the money towards their tuition fee to reduce your tax liability.
As soon as you get these essential savings and expenses in place, chances are you are left with little or no further money towards claiming tax savings under the Section 80C umbrella. If you are left with some more money to save taxes, check your life insurance needs and take an appropriate term insurance. Do not get tempted with other insurance plans that are tilted towards savings or investments. Term plans are a type of insurance that protect your family and dependents in case of exigencies.
10% New surcharge introduced for taxpayers with annual income between Rs 50 lakh to Rs 1 crore
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Once all these essentials are ticked off, you should consider putting the remainder into an equity-linked savings scheme (ELSS), for its short lock-in of just three years, though you could stay invested in the scheme like any other open- ended diversified equity scheme. The tilt towards market-oriented tax savings options is on the upswing because of the dwindling returns from fixed and guaranteed return instruments coupled with higher inflation rate, which is eroding money’s real worth. The option to use tax savings avenues into equity-oriented instruments is also favourable because equity is an asset class that has the potential in the long run to beat inflation.
Take for instance the long-term average return from the Sensex, which hovers about 16 per cent and is tax free, is worth considering as an opportunity to not only grow your wealth but also as an option to partake in the economic growth of the country. It is perhaps with this intent that the EPFO (Employees’ Provident Fund Organisation), which for years deployed its corpus into safe fixed return instruments has taken the step to allocate 15 per cent of fresh contributions each year into select equities for the past few years.
In similar manner, the contributions in the National Pension System (NPS) could also be considered, especially given the additional tax deduction of up to Rs 50,000 that one can claim under Sec 80CCD(1B) on contribution in the NPS. The advantage of mixing tax savings with equity investments is to benefit from the long-term gains of putting money in equities, which work the best when invested for 10- 15 years or more. These long-term tax savings gain from economic and stock market growth, besides the power of compounding which ensures that there is growth every year that the money stays invested.
Another important financial goal is to protect one’s health from unexpected scenarios. In this aspect the role of health insurance is profound. You must also take health insurance for yourself and your family, for which you can claim tax deductions under Section 80D. Depending on your age and stage in life you could save anywhere from Rs 25,000 to Rs 60,000 a year on taxes on premiums paid towards health insurance for self and family members.
Having seen the benefits of aligning your financial plans to tax plans, you have the option to choose the most suitable tax-saving instrument that meets your needs. Here are some ways to make the most of your tax savings this year. For instance, if you are living in a rented accommodation, claim the house rent allowance (HRA) by submitting the rental receipts or a copy of rental agreement with your employer. Note, if the annual rent exceeds Rs 2 lakh, then you are required to provide your landlord’s PAN as well.
Rs 2,500 The tax rebate under Section 87A for annual income up to Rs 3.5 lakh
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Avoid the mistake of getting carried away by paying rent to your spouse. However, if you are living in your parent’s house, you can pay rent to the parent on whose name the house ownership is. Try and limit the rent that you pay less than Rs 2 lakh in a year to make it tax efficient for your parent as well.
If you are retired and still need to pay taxes thanks to a good pension or investments that payout handsomely, you could consider a few fixed return tax saving options that exist. For instance, you could save taxes by putting money into the 5-year tax saving deposits or NSC to create an income streams in the years when they mature. So, if you are looking to use the entire Rs 1.5 lakh into a fixed- return tax saver, you could put Rs 12,500 each month in a financial year into a five year lock-in product in such a manner that on completion of five years, the maturity proceeds will act as an income stream, including the accrued interest.
If you live in a house with people across generations, you could consider creating an HUF (Hindu Undivided Family). This is a very effective and legal way to save tax, because the collective income of the family can be considered joint incomes as compared to individual incomes and are taxed in the hands of the whole family. The family as an HUF can have a separate PAN and claim tax deductions the same way as individuals do.
Remember; an HUF can earn income from all sources except salary. It can invest the initial corpus as well as gifts received subsequently to start a business and earn profits or capital gains. Ancestral property held by HUF can be let out to earn rental income. In fact, the HUF arrangement especially suits taxpayers who have income from ancestral property and expect to inherit financial assets. Such taxpayers will be able to divert the inheritance to the HUF, thus preventing taxation on such income in their hands at their maximum marginal rate.
One of the most efficient tax savings option is the ELSS because of its short lock-in of just three years compared to every other tax saving instrument which has typically more than five years of lock-in, with some going as high as 15 years in case of the PPF and longer if you consider the EPFO contributions. You could create a perpetual tax saving investment without any additional contributions from your end if you follow this method when putting money into ELSS.
5% TDS on rent applicable if monthly rent paid is more than Rs 50,000
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Start by putting money into ELSS for three successive financial years to benefit from the magic of compounding and equity investments. From the fourth year, you will be able to redeem your investment made in the ELSS in the first year, which will also be tax-free. This redeemed sum can be re-invested as fresh investments on which tax deductions can be claimed. So, effectively, your investment in year one, will fund the tax savings contributions in year four. This way, without committing fresh capital, you will have a long-term tax saving cycle, which will also free you of any fresh capital.
This strategy will work as long as the ELSS is posting gains and you are profiting from the investments. Considering these are equity investments, there is no guarantee that the ELSS will always be profitable, which is the only risk that you run. However, this tactic could be used to create a perennial tax-saving mechanism in an ELSS scheme that not just saves you taxes, but also frees you from making any fresh investments after the initial three years.
By deploying your tax savings into asset classes like equity and debt, you can match your risk profile and the most ideal asset allocation suited to you. Not only will you save taxes, you will also make sure that these tax saving avenues work in your interest. More often we ignore the obvious and look for ways to save taxes in the most mundane and obvious ways. While there is nothing wrong in doing so, but with little changes to this approach, you stand to gain by making the most of tax savings, which has the potential to make a real big difference to your finances.