Tax planning is not just about knowing the basics of taxation and investment but also about building long term habits and discipline.
With the financial year fast drawing to an end, it’s time for most of us to review the investments made for saving tax. On one hand, we have to conclude the current financial year and on the other, plan the investments for the next one. Tax planning is not just about knowing the basics of taxation and investment but also about building long term habits and discipline.
Given the sensitive nature of the phrase ‘tax planning and a lot of myths and misinformation surrounding the term, it is necessary to understand the legalities involved in any decision you make. Over the years, the Government of India and the Income Tax department have enhanced a lot of systems and processes to make it more taxpayer-friendly.
This article sheds light on important aspects of investment and tax planning that are relevant to retail investors. From a basic understanding of taxation to filing returns, we have tried to explain a few popular investment instruments. We hope you will find this article useful. Please do share it with your friends, colleagues, or anyone else who might be interested in learning the finer points of personal finance.
What is Tax Planning?
Tax planning is the process of analyzing and managing your finances from an income tax perspective. More specifically, it is done to reduce the tax liability through a combination of investments and by claiming deductions and exemptions available under various provisions of the Income Tax Act.
In other words, tax planning is the optimal utilization of exemptions, benefits, and rebates with suitable investments.
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Importance and benefits of early tax planning
Conventional financial wisdom tells us that it is never too early to start investing. Starting early offers several benefits:
● Well researched and planned financial goals
Starting tax planning early gives you time to research and visualise measurable financial goals. Understanding the various provisions and deductions available under the Income Tax Act can help make smart investment choices. It may also induce change in spending patterns and getting accustomed to new financial habits.
● Avoid paying extra tax
For salaried individuals, employers are considered responsible for deducting applicable tax based on an employee’s salary and their investment declarations. This is done in the form of Tax Deducted at Source (TDS) from the salary and paid on behalf of the employee. If sufficient tax-saving declarations are not made, employers may deduct a higher tax towards the end of the year and while you may get a refund later, your money will remain blocked for that duration.
● Liquidity for tax-saving investments
More often than not, people wait till the end of the year to make a lumpsum investment in tax-saving instruments. However, this can be difficult in uncertain economic conditions. Any volatility in the market can add unnecessary strain or financial burden and may even cause you to miss the investment targets. Thus, spreading the amount and allocating funds throughout the year allows you to manage liquidity.
● No last-minute hassle
Planning early and recording financial transactions throughout the year helps avoid last-minute rush and hassles. Knowing potential tax liability in advance also facilitates better cash flow and allows you to tap all available deductions and exemptions in an organised manner. Keeping the documentation of all financial transactions handy also minimises errors, omissions and glitches while filing income tax returns.
Difference between tax planning, tax avoidance and tax evasion.
The terms tax planning, tax avoidance and tax evasion are often confused and used interchangeably. From a legal perspective, the three are very distinct and the implications of not understanding them can be quite damaging. The table below will help to analyse these three terms better.
In a nutshell, tax planning is legal and done within the provisions of the law. On the other hand, tax evasion is a punishable crime.
Deductions and investment avenues for tax planning.
The Income Tax Act offers deductions on certain investments and payments. These deductions are applied before computing your income tax liability. Some of the popular tax-saving instruments are:
● Equity Linked Savings Scheme (ELSS)
Also known as a tax saving mutual fund, ELSS is an equity-based mutual fund offered by registered Asset Management Companies or mutual fund houses. Linked to the equity market, it has the potential to earn smart returns and is recommended for people with a slightly higher appetite for risk. Investments up to ₹1,50,000 for a minimum duration of 3 years are eligible for deduction.
●Unit Linked Insurance Plan (ULIP)
A combination of insurance and investment, ULIPs are offered by insurance companies. A portion of the money paid is allocated to provide life insurance and the balance is invested in equity or debt instruments. Investment up to ₹1,50,000 qualifies for deduction under Section 80C and gains upon maturity are exempt from tax, provided the annual premium paid is less than ₹ 2.5 lakhs.
● Sukanya Samriddhi Yojana (SSY)
This is a tax-saving deposit scheme launched by the Government for the all-round development of the girl child. Sukanya Samriddhi Account can be opened at the Post Office or any authorised bank by the parent or guardian of a girl child before she turns 10 years old. An annual deposit of up to ₹1,50,000 is tax-deductible. The Interest on the deposit is compounded annually and is fully exempt. All withdrawals and receipts upon maturity are also exempt from tax.
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● Public Provident Fund (PPF)
It is one of the most popular tax-saving investment schemes offered by banks and post offices. It is a long-term investment with a lock-in period of 15 years with provision for partial withdrawal every year after 7 years. Individuals can contribute a minimum of ₹500 and a maximum of ₹1,50,000 in multiples of ₹50 in an account in a financial year. The best feature of PPF is the triple tax exemption it offers - on the amount of contribution, the interest earned and the proceeds upon maturity.
● National Pension System (NPS)
It is a retirement-focused, long-term investment option open to all Indian citizens between the age of 18 and 70 years. The basic idea behind NPS is simple but very powerful. Invest while you are earning and get regular income in the form of an annuity when you retire. Restriction on withdrawal before retirement provides a long time to allow the money to grow. There are many prudent restrictions about the avenues where money contributed by NPS subscribers can be invested in pension return on the corpus at comparatively less risk and relatively lower cost.
● Some other popular investment options/deductions.
Understanding capital gain and capital loss on investment
Capital gain in the case of investments like shares and mutual funds is the profit made on sale or redemption. If the selling price is more than the purchase price, it is called capital gain. And if the selling price is lower, the difference is known as a capital loss.
The terms long-term capital gain (LTCG) and short-term capital gain (STCG) refer to the duration for which a financial asset or investment was held. If equity share or equity-oriented mutual funds are sold before 12 months, the profit earned is considered STCG. If the holding period is more than 12 months, then it is considered LTCG.
The Income Tax Act has no provisions to allow setting off of losses against any income or other heads except against capital gains. Long-term capital loss can only be set off against Long term capital gain and Short Term Capital Losses can be set off against both LTCG and STCG. Both Short Term and Long Term Capital Losses can be carried forward for eight years after the year the loss is incurred.
So, if you booked a loss of ₹25,000 on a stock after holding it for over a year, you can set it off against any long-term capital gain and any remaining loss can be carried forward for eight years.
● Tax on Equity and Debt Mutual Funds
● How to calculate STCG and LTCG while filing returns?
Calculating STCG and LTCG while filing IT returns requires 4 elements: the purchase price, the selling price, date of purchase and sale.
For example: Let us consider an individual who has purchased 1,000 shares of a company at ₹100 each for a total cost of ₹1,00,000. If he sells the shares within 1 year for a price of ₹125 per share, he will make an STCG of ₹25,000 and if he sells it at ₹150 per share after 1 year, he will book an LTCG of ₹50,000.
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Different tax regimes and how to identify which tax regime suits you?
The new optional tax regime
In 2020, Finance Minister Mrs Nirmala Sitharaman announced a new optional tax regime. The biggest change was the removal of all deductions and exemptions available under the old tax regime. It is for the taxpayer to choose the tax regime. To understand which regime suits you, let’s begin by understanding the key differences between the two regimes through an example of a typical salaried individual under the age of 60 years:
Which tax regime suits you?
Both tax regimes have their pros and cons. While the old system has higher tax rates, it also offers multiple options to reduce tax liability. But then again, multiple deductions and complications can add work and complexity. The new regime on the other hand is simpler with reducing tax rates as you move higher up the tax slab. But avenues for saving tax are few and with a focus on liquidity in hands of the taxpayer, the motivation for overall saving is lesser. As income sources and deductions differ for every individual, it is not possible to apply one rule for all. Taxpayers must evaluate and compare the tax liability under both regimes and then decide which one to opt for. In case a taxpayer has already made investments in different tax saving instruments and avails the benefit of the deduction for HRA, LTA, etc. it may be more beneficial to opt for the old tax regime.
Filing Income Tax Return (ITR)
An ITR is a document that captures an individual’s income, exemptions and deductions claimed during an assessment year. It also includes tax payments made by a taxpayer or on their behalf in the form of tax deducted at source by employers on salary etc. It is mandatory for all Indian citizens with an annual income of more than ₹2,50,000 to file an ITR even if you are not liable to pay income tax. Most salaried individuals are expected to file their returns by July 31 and failure to do so can attract a penalty.
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Benefits of filing an ITR
● Getting loans or raising funds: An IT return is a summary of your financial health so getting a loan or raising funds becomes easier. In most cases, it is a compulsory document.
● Travelling abroad: IT returns have become a mandatory requirement for visa applications to many countries. Returns from recent years are used to gauge the financial stability of an individual and are key in deciding whether or not to grant the visa.
● Claim refund: If you do not have any tax liability or any excess tax has been deducted by your employer or any other party at the source, you can claim a refund of all such taxes. This is ascertained during the process of filing your IT return.
The process of filing an income tax return
● Gather the relevant information and documents:
Form 16: This is a certificate of tax deducted at the source (TDS) by your employer(s). It includes details of your salary including complete salary break-up, tax-exempted allowances, perquisites, etc. All employers must issue Form 16 to their employees. The TDS is connected to your PAN, so ensure that your PAN is mentioned correctly in Form 16.
Form 16A: Form 16A is a TDS certificate on Income ‘Other than Salary.’ For example, if you work as a freelancer, you will be issued Form 16A by the clients to whom you provide service.
Form 26AS: Issued by the Income Tax department, it is a statement provided to taxpayers with details of all taxes paid by and refunds due to them. It also includes TDS deducted, paid on your behalf by employers, banks and other entities who have made payments to you.
Proof of deductions: Ensure you have supporting documents for all deductions claimed under various sections of the Income Tax Act. This includes receipts for life and medical insurance premiums, receipts for tax-exempted donations, signed rent receipts with details of landlord’s PAN, statement of interest from banks, receipts of earnings from investments among others.
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● Choose the right ITR form:
ITR forms have been designed based on the category of taxpayers. The following ITR forms are applicable for individual taxpayers –
ITR-1 or SAHAJ: For salaried individuals and pensioners, who have income from one house or earn ‘Income From Other Sources’ (such as returns on investments). The total income should not exceed ₹50,00,000 and should not include ‘Capital Gains’, gains from other businesses or professions or winnings from lotteries or horse racing.
ITR-2: For individuals with a total income of more than ₹50,00,000 and who do not have additional income from ‘Business or Profession’.
ITR-3: For all individuals who have additional income from ‘Business or Profession’.
ITR-4 or SUGAM: This is based on presumptive earnings for the year, for a cumulative annual amount up to ₹50,00,000.
● e-filing of income tax return: It is mandatory to file Income Tax returns at (www.incometax.gov.in/iec/foportal). There are few exceptions such as Super Seniors over the age of 75 and taxpayers with an annual income under ₹5,00,000.
- Register: Register on the above portal with PAN and basic details.
- Select ITR form: Choose Assessment Year and the right ITR Form.
- Enter general information: PAN, Aadhaar and other relevant information.
- Compute income and tax payable: Include details of all incomes and deductions claimed. After including details of the taxes already paid you will get the next payable tax liability.
- Pay tax or claim refund: If your total tax due is more than the total tax paid, you will be directed to e-Pay for paying the tax online. Alternately, if the total tax paid is more, you would be able to claim a refund.
- Submit ITR: After going through all these steps, submit your ITR and download the acknowledgement.
- e-Verification: Unverified ITRs are not processed by the IT department, so this is the last but most important step. Your ITR can be e-Verified on the portal using EVC, Aadhaar or Demat account or through your net banking portal.
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Importance of PAN
PAN is one of the most crucial documents, not just for tax purposes but also as a proof of identity. Often there are reasons for the change in PAN information like name change after marriage, change in address, mobile number or email ID. Sometimes people lose PAN cards or may like to change the photograph on the PAN card.
Consequences of non-compliance
● If an individual required to furnish an ITR fails to do so within the time prescribed, they would have to pay interest on tax due and a late filing fee of ₹5,000.
Do’s and Don’ts of tax planning
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Disclaimer: We make all articles for educational purposes. We don't give any buy/sell recommendations. Before investing in any stock do your own research and then invest in the long term.
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