Tax planning to earn tax-free income

Source: The Hitavada      Date: 17 Sep 2018 15:17:00


 


 

 

In this week’s article, we are going to discuss two tools that if used optimally can save you heavy taxes. Both when used simultaneously create an amazing synergy in a person’s tax savings. Read on to know more.

The first tool is your basic tax threshold. Readers would know that the first Rs 2,50,000 of income is exempt from tax. For senior citizens (60 plus) the limit is Rs 3,00,000. So far, so good.


The second tool that works hand in hand with the first is known as Sec 56 of the Income Tax Act.
Sec 56 basically exempts cash gifts between relatives. Though there is a long list specified in the section, for our purposes, suffice it to know that as per the Tax Act, you, your parents, your brothers and sisters as well as your children are all relatives of each other.


Now in order to understand how these two tools can be used for some smart tax planning, let’s take the example of one Mr Mehta who is 49 years of age. He happens to be in a senior management job which puts him in the highest tax bracket. He has retired parents who live with him. His wife is a home maker. And he and his wife are also proud parents of an 18 year old daughter and a 20 year old son who are both studying in college.


Read Mr Mehta’s profile once more if you must because it is important in our scheme of things. Also remember that some of the numbers that are going to be thrown up are astonishingly large. Don’t get thrown off because of that. This is just the power of these tools at work. You can use them at any income level to suit your particular situation. What’s important is understanding the concept, individual numbers can always be plugged in.


Now Mr Mehta like most of us finds that beyond a point, tax saving isn’t possible. Sec 80C etc can cover only so much. But most middle and higher management employees earn more than the tax saving avenues can cover. Moreover, every rupee of post tax paid income that Mehta invests in say RBI Bonds, Bank FDs, Post Office MIS or its like is subject to the highest rate of tax. If he doesn’t want to pay tax, he is forced to adopt market risk by investing in equity shares or mutual funds. However, he finds the stock market to be too whimsical for his liking -- while it gives a reasonably good return for a period of time, it is risky and volatile. Already suffering from hypertension, no beta blocker in the world could prevent his pressure from outswinging the market.


It was at this delicate juncture that Mr Mehta was introduced to our tax planning tools by an old chartered accountant friend of his. This is what Mr. Mehta did after his brief but illuminating chat with his friend.


He gifted Rs 40 lakh to his father and a similar amount to his mother. This gifted money was invested by his parents respectively in a bank FD yielding 7.5 per cent pa. Which basically meant that both Mr Mehta’s father and his mother earned Rs 3, 00,000 as interest from the FD (each earned 7.5 per cent pa of Rs 40 lakh). However not a penny of this was taxable as it is not beyond the initial tax slab available to senior citizens.


In one stroke, Mr Mehta, effectively made income from Rs. 80 lakh of capital tax-free in the family’s hands. Realise that had Mr Mehta invested the funds himself, he would have paid full tax on it. However, since the gift was tax-free and the tax slab was available, this strategy could be put to work.


Now, Mr Mehta finds that his children have some time to go before they start earning. His daughter and son can earn up to Rs 2,50,000 each without having to pay tax. But they aren’t earning as of now, are they? They are studying and will continue to do so for the next five to seven years. So what does he do? He gifts them around Rs 30 lakh each. This money in turn is invested in a similar bank FD by the kids thereby earning Rs 2.50 lakh respectively. Of course, as explained earlier, no tax would be payable. (The exact amount of capital is Rs 33.33 lakh and not Rs 30 lakh - but we have rounded off for simplicity of understanding)


In effect, by using two simple tools that the Income Tax Act offers, Mr. Mehta had managed to Rs 2.50 lakh X 2) of income tax-free for the family. Putting it differently, Rs 1.40 crores of capital make Rs 11 lakh (Rs 3 lac X 2 plus was deployed (Rs 40 lakh X 2 plus Rs 30 lakh X 2), however, the income therefrom was totally tax-free.


Note carefully that it is not Rs 1.40 crores of income that is rendered tax-free, it is the income on a capital of Rs 1.40 crore lakh (around Rs 11 lakh) that is sought to be made tax-free.


Now admittedly, Mr Mehta is an extremely rich man. He had Rs 1.40 crore to spare in the first place before trying to make it tax-free. Not everyone will have this kind of money. However, the example given is an optimal one. You can use a similar strategy with the funds at your disposal and the benefit you derive will be proportional. In other words, it’s not an all or none strategy... use it to the best of your ability.


Also note that Mr Mehta’s profile was an ideal one. Man working in the highest tax bracket with retired parents having no income of their own and two major children who are still studying. Again, not every taxpayer will have a similar profile. You father may be having taxable income but your mom may not be working. Or your children may be earning already. However, the idea is to use that particular element in the equation which applies in your case directly.


Last point
Beyond a point (barring ideas such as discussed above) tax saving is not possible. The worst mistake any investor could make is to invest with the primary objective of saving tax.
The question to ask is would you have made the investment if it didn’t offer tax saving? If the answer is no, don’t touch the investment. It’s better to try and optimize post tax income instead of making a sub-optimal investment just to save on tax. Or like US President Donald Trump has once said, some of your best investments are the ones that you don’t make.

(The authors may be contacted at
[email protected])