Everything about Income Tax Planning

Introduction: Before we go into the details of income tax planning, let’s understand few key principles of income tax itself.

A common man like you and me can earn income from diversified sources. Majority earn income from a single source like job or business.

But there are people who earn income from variety of sources.

From the point of view of income tax, all incomes has been categorized into 5 types. All type of incomes attract income tax.

Of course there are exemptions provided on some form of incomes. But even before income is taxed or exempted it is essential to learn to categorize one’s source of income.


In terminology of taxation, categorizing income is commonly referred as “heads of income”.

It is extremely important for the tax payer to first categorize his income under right heads. This becomes extremely important for those people who have multiple source of income.

In terms of income tax planning, it all starts with defining right heads for each flowing-in income.

#1. Start Income Tax Planning: Define heads of income

INCOME TAX PLANNING - INCOME TAX

#1.1. Income from salary:

When a person received a paycheck from a company for his job, it is called as salary. Anybody paying some money to the other cannot be treated as salary. There must be a contract existing as per rule of law which can established that one entity is an employer and other is an employee.

As a general rule, an employee receives following remunerations from its employer. In income tax terms it is called as wages, fees, allowances, advances, gratuity, pension, retirement benefits etc.

#1.2. Income from house property:

The income earned by an owner of house property is taxable. In case the house property is self-occupied, there will be no income. So tax liability is zero.

But if the house property is let-out on rent, then this income in hands of the owner, becomes taxable.

Let’s see how tax liability on income from house property is calculated.

The formula is like this:

#1.3. “Profits” from business:

You note here that term used here is profit and not income. What is the difference between income and profit?

Income from business, minus the allowable expenses incurred while running the business, is profit.

Profit made by the business is liable for taxation.

In order to compute profit from business, it is essential for the tax payer to be aware about which expenses are allowed and which are not-allowed as deductions. Otherwise one may end up calculating ones profits wrongly.

#1.4. Capital gain:

Generally, valuation of assets appreciates over a period of time. When such an asset is sold by the owner, the profit made in the sale is liable for tax.

Not all types of asset sale attract tax. Personal asset in general do not attract income tax. But there are exceptions here as well.

Few assets whose profitable sale attracts income tax are immovable property, movable property, jewellery, art work like painting etc attract tax.

As per income tax act, capital gain is further categorized into two parts: short term capital gain & long term capital gain.

Depending on the time period for which the asset has been held by the seller, the capital gain is tagged as short or long.

Short term capital gain will be applicable if the asset has been held for less than 3 years. For paper assets like stocks, mutual funds, ETF’s etc, short term capital gain will be applicable only if asset has been held for less than 1 year.

All capital gains, not coming under short term capital gain, is liable for long term capital gain.

INCOME TAX PLANNING - HEADS OF INCOME

#1.5. Other income sources:

We have all type of income categorized above from 1.1 to 1.4. But still there are few uncommon types of income that do not fall under the above category.

Some common income sources which fall under 1.5 are dividend earnings, interest earnings, gifts, PF income, income from games like lottery, race course,  etc.

#2. Types of income exempted from tax

People often think that government will tax all income. But this is not correct. There are few income types which do not attract any income tax. Let’s see some common income types exempted from tax net:

  • Agriculture income
  • Salary received from employer as LTA (conditional apply)
  • Income upon retirement in form of gratuity, pension, leave encashment, compensation received upon voluntary retirement (up to prescribed limits)
  • Income from insurance policy including bonus
  • House rent allowance up to prescribed limits
  • Dividend income received from companies on which dividend distribution tax has been paid.
  • Long term capital gain tax applicable on sale of stock, pure equity mutual funds,
  • Etc.

#3. Allowable deductions on income

To promote some type of expenses, government give incentives. This way they indirectly ask people to spend money in a certain way.

These allowable deductions in turn help people to save on tax. Lets see here few deductions that people can utilize to reduce their income tax liability:

Section 80C: Allowable amount that can be claimed under section 80C is Rs.150,000.

Few common expenses for which deductions can be claimed u/s 80C are as below:

  • Life insurance premium paid for family (self, spouse & child)
  • Annuity contract payment for family (self, spouse & child)
  • Contribution to EPF, superannuation fund etc
  • Contributions to PPF for family (self, spouse & child)
  • Money deposited in Post Office Savings Bank in 10Y or 15Y a/c
  • Amount spent to purchase NSC
  • Amount spend to purchase ELSS
  • Amount spend to purchase pension funds offered by mutual funds
  • Purchase of deposits issued by National Housing Bank (NHB)
  • Tuition fees paid to school, college for full time education
  • Principal portion paid for home loan
  • Selected fixed deposits of scheduled bank
  • Payments to Bonds issued by NABARD
  • Savings under SCSS
  • Purchase of 5Y term deposit of Indian Post Office

INCOME TAX PLANNING - 80C DEDUCTIONS

Section 80CCC: Premium payment towards annuity plan of LIC

Section 80CCG: Premium payment towards RGESS

Section 80D: Allows deductions for premium payment upon purchase of health insurance policies

Section 80DD: Allows deductions for expense incurred towards maintenance of a disabled person

Section 80DDB: Allows deductions for expense incurred towards medical treatment of senior citizens

Section 80E: Allows deductions for expense incurred towards interest payment of education loan

Section 80G: Allows deductions for expense incurred towards contribution to certain charitable trust

Section 80GG: Allows deductions for Expense incurred towards payment of rent if HRA is not received from company

Section 80U: Allows deductions for expense incurred towards maintenance/treatment of self of disabled person

Section 80TTA: Allows deductions for interest earned from savings back account up to Rs.10,000.

#4. Who must pay Income Tax?

In fact, anybody who is working in India and is making money, should pay income tax to the Government of India.

But the tax liability substantially varies depending on who is paying the tax.

As per income tax act, the tax payers has been categorized into the following ways:

  • As Individual
  • HUF (Hindu Undivided Family)
  • Company
  • Firm
  • Association of persona
  • Local authority &
  • Other people no included in above list

#4.1. Who is an individual?

Following people becomes an individual who must pay tax on his/her income:

  • Person who has been residing in India for last 182 days or more in the previous year
  • Person who has been residing in India for last 60 days or more in the previous year and 365 days or more in the 4 years preceding to the last

Non-resident individual: An Indian citizen who does not qualify the above criteria becomes a NRI. His NRI status makes his tax liability different than a “Normal Individual”.

The income earned by NRI’s by investing in assets are treated differently than other individuals. Interest earned on deposits maintained by an NRI in Indian banks (FCNR / NRE) do not attract tax.

If an NRI invests in shares, deposits, debentures etc in India, their short term gain will be taxed at a flat rate of 20%. In case of long term capital gain, tax rate applicable will be only 10%.

Person of Indian Origin (PIO): A person who has ever held an Indian passport in the past is a PIO as per income tax act.

If a citizen of India has a grandchild being born and brought up abroad, is eligible for being a PIO.

If a foreign national, marries a person who had an Indian passport in the past or is grandchild of an Indian citizen is also eligible for being a PIO.

#4.2. Who is HUF?

In a Hindu undivided family (HUF), assets belong to a family and not to any specific individual. In such a case HUF is treated like an individual. But of course, the income tax levied on HUF is different from an “individual”.

All persons in a family can jointly form a HUF. But the condition is only one, they should be descendants from a common ancestor. In HUF, spouse and unmarried daughters can also included.

#5. Income tax slabs prevailing in India…

Gross total income, minus allowable deductions gives net taxable income. On this next taxable income, one must apply the government approved tax slabs.

Once the tax slabs are imposed on the taxable income, one’s tax liability can be calculated.

Every year in the Union Budget, the Finance Minister of India confirms/alters the prevailing tax slabs applicable on one’s income.

So one may ask why there are tax slabs and not one single tax rate? The theory goes like this; there should be less burden on tax on poor people, and more burden on rich people, who can afford to pay higher taxes.

Based on this concept, the prevailing tax slabs in India is as below:

Age < 60 years (Men, Women & HUF)

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
Zero < TI < 2,50,000 No Tax
2,50,000< TI < 5,00,000 10%
5,00,000< TI < 10,00,000 20%
TI > 10,00,000 30%
50,00,000 < TI < 1,00,00,000 30% (Surcharge of 10% on Income tax)
TI> 1,00,00,000 30% (Surcharge of 15% on Income tax)

60 years < Age < 80 years (Men & Women)

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
Zero < TI < 3,00,000 No Tax
3,00,000< TI < 5,00,000 5%
5,00,000< TI < 10,00,000 20%
TI > 10,00,000 30%
50,00,000 < TI < 1,00,00,000 30% (Surcharge of 10% on Income tax)
TI> 1,00,00,000 30% (Surcharge of 15% on Income tax)

Age > 80 years (Men & Women)

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
Zero < TI < 5,00,000 No Tax
5,00,000< TI < 10,00,000 20%
TI > 10,00,000 30%
TI> 1,00,00,000 30% (Surcharge of 15% on Income tax)

#6. Applicable income tax benefits…

Like salary attracts income tax, investment income also attracts tax. In general, all investment income can be categorized into the following categories:

  • Dividend
  • Interest
  • Capital gain

An investor will earn dividend when the issuer of security (like shares of companies) pay it to their shareholders. In a similar way, interest income is earned by the investor.

But capital gain is realized only when the investors sells their asset holdings.

How investments can provide tax benefits to investors?

#6.1 Tax Exemptions:

Dividend income from shares and mutual funds in hands of investors are completely tax free. In taxation terms it is called as “Exemption”.

#6.2 Tax Deductions:

Investments made as per section 80C  can be claimed as deductions by the investors up to an upper limit of Rs.150,000 per year. In taxation terms it is called as “deduction”.

#6.3 Tax Rebates:

The calculated income tax liability can further be reduced by applying “rebates” as per income tax rules. For people whose taxable income is less than Rs.500,000 are eligible to claiming Rs.2000 rebate on the tax liability.

#6.4 EEE & EET

There is another rule in income tax act which is popularly being quoted as EEE & EET. EET: As per this rule, investment made are exempted from tax. Income from such investments are also exempted. But when the investment is redeemed, the sale proceeds are taxable. Few examples of investment that give EET benefits are ULIP, Pension Schemes & NPS. EEE: As per this rule, investment made are exempted from tax. Income from such investments are also exempted. Even the redeemed amount is exempted from tax. Few examples of investment that give EEE benefits are EPF & PPF.

#6.4 EEE & EET

There is another concept called “Marginal Rate of Tax”. As per this rule, not everybody is taxes similarly. Like a person below 60 years of age are taxed differently than people above 60 years of age. NRI’s are taxed differently that resident Indian nationals.

Lets try to understand the concept of marginal tax rate with an example. Suppose your taxable income (salary) is Rs.12 Lakhs. You also invested some money in bank deposit where in you have earned an income of Rs.40,000 in last year. How your total income will be taxed?

The answer is, the total income will be taxed at the applicable marginal rate of tax. What does this mean? Actually the authorities are saying you to compute your tax liability as per your applicable tax slabs.

So lets calculate your tax liability as per prevailing income tax slabs.

Salary Portion: Rs.12,00,000

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
Zero < TI < 2,50,000 No Tax
2,50,000< TI < 5,00,000 10% (10% of 250,000 = 25,000)
5,00,000< TI < 10,00,000 20% (20% of 500,000 = 100,000)
TI > 10,00,000 (Rs.200,000) 30% (30% of 200,000 = 60,000)

Interest Income Portion: Rs.40,000

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
TI > 10,00,000 (Rs.40,000) 30% (30% of 40,000 = 12,000)

Here you will note that the interest income is being charged 30% tax rate and not 0%, 10% or 20%. This is what it means by margin tax rate. The highest rate applicable for your salary income will be applicable on interest portion of the bank deposit.

Lets see another example:

Taxable income from job Rs.995,000. Interest earned on bank deposit Rs. 26,000. What tax will applicable on interest earned on bank deposit?

Salary Portion: Rs.8,00,000

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
Zero < TI < 2,50,000 No Tax
2,50,000< TI < 5,00,000 10% (10% of 250,000 = 25,000)
5,00,000< TI < 9,95,000 20% (20% of 495,000 = 99,000)

Interest Income Portion: Rs.26,000

Taxable Income (TI) in Rs. Tax Slabs (Applicable Tax Rate)
5,00,000< TI < 10,00,000 (Rs.26,000) 20% (20% of 26,000 = 5,200)

#6. How dividends paid by mutual funds are taxed?

We know that dividends paid by companies are tax free in the hand of the shareholders. But not many people know how dividends paid by mutual funds are taxed.

The problem with mutual funds is that they are not of same type. So, when mutual funds pay dividends, it is pertinent to understand what is the source of income.

One type of mutual funds are equity based. These funds has a portfolio which is 65% or more rich in equity. These equity linked funds earns majority of short term income in form of dividend paid by stocks of companies. As corporate dividend tax (CDT) is already paid by the companies,  hence Dividend Distribution Tax (DDT) is not applicable here.

Other type of mutual funds are debt based. These funds has a portfolio which has equity component less than 65%. These debt funds earns majority of short term income in form of interests. Here Dividend Distribution Tax (DDT) is applicable here. As per DDT, 30% tax should be applicable on the gross dividends allocated by mutual fund companies for disbursement. DDT should be paid by the mutual fund company before distributing the dividends to unit holders.

#7. How interest income is taxed?

Interest income is taxable at the marginal tax. But not all interest is taxable. Government of India do provide some exemptions in interest income as well.

There are tax free bonds issued by government of India. A good example of such a bond is Infrastructure bond, NHAI Bond etc.

When NRI parks their money in India in form of bank deposit, the interest earned by such deposits are tax free.

There are some debt linked financial instruments, whose interest income is subjected to TDS. This TDS is collected to ensure that a portion of tax is received by the government upfront. The interest income is paid to shareholders only after TDS deduction.

#8. Indexation benefit and income tax liability?

Indexation can dramatically reduce ones “long term capital gain” tax liability.

Indexation is nothing but adjusting ones cost of investment purchase for inflation.

Let’s see how this is done:

Example: Suppose you bought a mutual fund unit which offers indexation benefits at Rs.150 in year 2012-13. The units purchased in 2012-13 was sold in year 2016-17 at price of Rs.200. What will be the capital gain in a normal case? What will be the capital gain applying indexation?

Long term capital gain (without indexation) will be Rs.50 (Rs.200-Rs.150).

Now lets apply the indexation. To do this we will have to see the Cost of Inflation Index (CII) published by government of India. This is very readily available in internet. From this chart I could get the following data:

  •         Index for year 2012-13: 852
  •         Index for year 2016-17: 1125

Actual cost of purchase of mutual fund units. Rs.150

Cost of purchase of mutual fund units (using indexation formula):

Cost after indexation = (index in year 2016-17 / index in year 2012-13) X Actual cost of purchase

= (1125/852) * 150 = 198

Long term capital gain (after indexation) will be Rs.2 (Rs.200-Rs.198).

You can see, how long term capital gain has gown down from Rs.50 to Rs.2 due to indexation.

#9. How capital gains are taxed?

Equity (Shares & equity oriented mutual funds):

  • 15% – Short term capital gain tax (STCG)
  • Exempted – Long term capital gain tax  (LTCG)

All other securities:

  • At marginal tax rate – Short term capital gain tax (STCG)
  • 10% – Long term capital gain tax  (LTCG) – without indexation
  • 20% – Long term capital gain tax  (LTCG) – indexation

Exemptions:

  • LTCG is exempt from tax on sale of residential property if the profit is reinvested back to buy or construct another residential property in India. The new residential property must be purchased within 1 year of sale of earlier property.
  • LTCG is again exempt from tax on sale of residential property if the profit is reinvested back to buy a bond issued by NHAI or REC. This bond has a lock in period of 3 years. The maximum LTCG that can saved using bond route is Rs.50 lakhs.

Final Words…

If one know the key income tax rules, it is possible to drastically reduce one’s tax liability. This can be done by investing one’s money in such a way that, in addition to providing investing advantage, it also saves tax in short term.

As a honest citizen of country, it is good to pay tax to the government, but overpaying tax is not advisable.

When Government allows us to save on income tax, then why to overpay it? Over payment of income tax can be prevented by doing immaculate income tax planning.

I know that a big majority would like to save income tax in an ethical way. But they fail to do so in absence of right information. I hope this article will provide the needful information all in one blog post.





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About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

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