Come July and every tax-paying individual gets busy filing his/her tax returns. As the logic goes more the income more the tax one has to pay. Everyone likes to grow economically but at the same time hates paying taxes. Albert Einstein once famously said that understanding Income Tax was the hardest thing for him in the world. But jokes apart the solution to every problem doesn’t lie in running away from it, but instead understanding it and income tax is no different. Through this article I will run through some useful tips on how to minimise your taxes on income from investments.
Risk free Investments
Any investment that is generally considered to be free from risk of monetary loss and which gives an assured return is a risk free investment. The most common avenue of risk free investment known to layman is a bank fixed deposit. But hold on, although fixed deposits are relatively risk free the interest earned from them is not free from tax. So if you are looking for a safe investment and at the same time want to save on tax from the income earned through it look for options from debt based mutual funds like fixed maturity plans (FMP’s), income funds or dynamic bond funds. Let me explain with the help of an example.
Nikhil who earns of salary Rs 10 lakh per annum invests Rs 1 lakh each in bank fixed deposit and fixed maturity plan of a debt based mutual for a period of 5 years starting April 1, 2011. Assuming both investments give the same return ie 9% per annum he will earn Rs 9,000 as annual interest from each of the above investments. Coming to taxes, interest on fixed deposit is taxed at marginal income tax rate and hence in his case will be taxed @30% as the gross total income ie income from salary plus Interest on fixed deposit exceeds Rs 10 lakh. He will have to pay an Income Tax of Rs 2, 700 on the interest earned from fixed deposit (30% of Rs 9,000) per year. I have ignored surcharge and cess. On maturity he will cumulatively earn Rs 1,45,000 (Rs 9,000 interest per year *5years) – tax of Rs 13,500 (Rs 2,700 tax per year *5 years) ie Rs 1,31,500 which works out to be only 6.3% returns per annum post tax.
On the other hand, in case of his investment in fixed maturity plan of a debt mutual fund, the tax liability arises only at the time of maturity of the FMP and hence is not required to pay any tax till its maturity. Because the holding period is greater than 3 years, the resulting income shall be treated as long term capital gains and taxed at a special rate of 20% after accounting for indexation. Indexation is the process that takes into account inflation from the time you invest in the asset to the time of its maturity. It’s worth noting that in the earlier case interest on fixed deposits don’t get the benefit of indexation. Indexed cost of acquisition is calculated using the formula ((Cost inflation index of the year of maturity/ cost inflation index of the year the investment was made)* Amount of investment). So his profit from FMP will be Rs 7, 293 ie Rs 1,45,000 maturity value – Rs 1,37,707 ie the indexed cost of acquisition (1081/785*Rs 1,00,000). He will pay tax @20% on the above profit (Rs 7293*20%) which comes to Rs 1,458. Hence post tax he will earn Rs 1,43,542 (Rs 1,45, 000 – tax 1458) which works out to be 8.7%.
Conclusion
Even before I began writing this article, I was mindful of the calculations involved in proving my point. But I wanted my readers to understand that by doing some investments differently we can earn more by saving on taxes. Don’t be afraid to change. You may lose something good, but in the bargain you’ll gain something better.
