These days, people can earn an income through several different avenues: you can work a nine-to-five job, take up freelancing and part-time gigs, monetise your hobbies, start a small business, earn rental income on your property, or earn interest income from investments. But regardless of how you make money, as soon as you have an income, the government requires you to file an Income Tax Return (ITR).
It’s through your ITRs that the government keeps track of how much income you earn in a year and, accordingly, how much tax you owe. Now, while evading taxes is a serious crime, there are several ways in which you can legitimately reduce your tax liability in any given financial year. The Income Tax Act 1961 has several sections and provisions that allow you to reduce your taxable income and, thereby, the tax that you are liable to pay.
Here are some effective tips for minimising taxes and maximising deductions:
- Understand which tax regime to follow
When filing taxes, the default tax regime now is the new tax regime that was introduced in Budget 2020 to simplify the tax filing process for individuals. It lowered tax rates, but also removed several deductions and exemptions. You can still opt for the old tax regime, which has higher tax rates but allows for a wider range of tax deductions and exemptions, including Section 80C.
The income you earn and the tax-saving investments you make will help determine which tax regime is more beneficial for you. For instance, if you make absolutely no tax-saving investments and have no life or health insurance policies either, then the old regime doesn’t make much sense for you since you don’t have anything to claim to reduce your tax liability. You should discuss this with your accountant or financial advisor before you decide to make any tax-saving investments.
- Make tax-saving investments
Your investment planning should not only focus on wealth generation but also tax-saving, insurance coverage, and retirement planning. There are several investment products that help with both tax-saving and retirement planning, including the National Pension System (NPS) and Public Provident Fund (PPF).
You can also consider investments like the Equity-Linked Savings Scheme (ELSS) and insurance products like life insurance and health insurance. For all these investments, you can claim a deduction of up to ₹1.5 lakh under Section 80C of the Income Tax Act if you are following the old tax regime. Some of these investments, like the PPF, also have ‘EEE’ status — that is, they are exempted from tax on the investment amount, the interest/returns earned, and the maturity amount.
- Be strategic about investment horizons
You can also minimise taxes by planning your investments well and taking into consideration their investment horizons. For instance, capital gains on equity investments like stocks, equity mutual funds, etc. are classed as either Short-Term Capital Gains (STCGs) or Long-Term Capital Gains (LTCGs), depending on the duration for which you hold the investment.
Gains on equity investments held for less than 12 months are considered STCGs and taxed at 15%, while gains on equity investments held for over 12 months are treated as LTCGs and taxed at 10%. In addition, LTCGs on equity investments are tax-exempt for an amount of up to ₹1 lakh per financial year. So, by holding your equity positions for a long time, not only do you hedge against the risk of market volatility, but you also reduce the tax on your returns.
- Invest your capital gains
When you sell assets like property or even stocks, you can make significant capital gains if the selling price is much higher than the price at which you purchased the asset. To avoid paying capital gains tax in such cases, you should consider investing those gains in bonds classified as ‘capital gains bonds’.
Under Section 54EC, you can invest your capital gains in certain specified bonds within six months of the date of the sale of the asset to save on LTCG tax. These bonds include bonds issued by the Rural Electrification Corporation Ltd, the Power Finance Corporation Ltd, and the Indian Railway Finance Corporation Ltd. The maximum amount you can invest in these bonds is ₹50 lakhs.
- Check which expenses can be claimed
The Income Tax Act not only provides tax deductions and exemptions for certain investment products but also for specific expenses that you might incur. For instance, you can claim deductions for the interest paid on education loans and home loans under Sections 80E and 80EE respectively.
You can also claim deductions for donations to certain charitable organisations, medical expenses for specified diseases, medical expenditures for a disabled dependent, etc. Such deductions help lower your total taxable income and can help reduce your tax liability significantly.
- Invest in countries India has a DTAA with
A well-diversified portfolio includes international exposure in accordance with your risk appetite and financial goals. Investing in the markets of a country with which India has a Double Taxation Avoidance Agreement (DTAA) can help you lower your tax burden. For instance, India has a DTAA with the US. As a result, if you’ve invested in American assets, you are not liable to pay taxes on your investment income and capital gains in both the US and India. Instead, you can claim tax credits when filing your ITR to prevent double taxation.
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Make strategic investments for lower taxes
Investing is a powerful tool that helps you meet your various financial needs. From building wealth over the long term to minimising taxes on your income, strategic investments can allow you to benefit on several financial fronts. Depending on your income level, investment strategy, and the applicable tax laws, there might be several other things you can do to make the most of the deductions and exemptions provided for in the Income Tax Act. Hence, consider consulting a financial advisor to plan your investments more effectively.
