Financial Literacy for the 20-something: Part 2— Income Tax
Welcome back to the dad talk that you didn’t know you needed!
I can sense the dazed and apathetic expression on your face, but grab a coffee or soy milk frappe or whatever and bear with me. We’re going to be diving into the bane of every salaried worker’s existence.
By the end of this article, you should have a good grasp of where the government bites your ass and what you can realistically expect to save if you do everything right.
As always, we’re going to start off with a quick look at your payslip. If you don’t have a clear understanding of your payslip, I suggest you skip this and read this article first.
Why is Income Tax such a big deal?
I want you to focus on that line on the deductions side of the payslip called Income Tax. As the title suggests, it's a tax that the government levies on your income, because you’re supposed to be one among the 14.6 million people in India who pay tax to the government out of the 1.3 billion people that walk this hallowed land of plenty. Picture yourself as the Greek god Atlas carrying 20% of every single public water tank, metro train, roadway, railway track, hospital, publicly distributed sack of rice, and government employee and multiply that by 10000 times for all the items I haven’t listed here. And then imagine having to wince watching your government use that money to build a giant statue for political mileage. To make sure that the entire slave population of Indian middle-class employees doesn’t rise up in rage at this unfair levy, the government has provided tax exemptions on your salary based on how you use it. There are limits to these exemptions but they’re large enough to lull you into thinking you’ve saved a tonne of change when you’ve just stolen pennies from the jaws of the government while they’ve pretended to turn away. I digress, but I just wanted to impress upon you the importance of that single line on your payslip.
How do I file my taxes?
Unlike in the United States, where you’re supposed to file your taxes by yourself (and get hounded by the IRS for every penny you miss), Indian employers follow a system called Tax Deducted at Source (TDS). This means that your employer deducts the income tax from your salary every month on your behalf and credits the tax deducted salary to your account and your income tax to your tax account care of the government. Your tax account gets connected to you through your PAN (Permanent Account Number). Every financial activity that you undertake in life be it opening a bank account, buying property, buying a car, taking out a bank loan requires you to provide your PAN and is monitored by the IT department. Talk about Big Brother, huh? Your company deposits your income tax in your tax account and the government provides you a receipt titled Form 16 (A & B).
Your salary income is just one part of your income. It’s the easiest to tax and file because of your company doing the work for you. You might be earning income from a business you own, the interest on your savings deposits, stocks you sold, and many other hopefully legitimate sources. You have to provide the details of these incomes and file your income tax return on the government income tax website.
Tax exemptions under the Income Tax Act
The income tax has many sections that specify which spending and investment activities are exempt from taxes. The key sections which I use and which I’d like for you to keep in mind are:
Standard Deduction: For salaried employees, the government straight away exempts tax on INR 50000. Small mercies, I guess.
80C — Investments: Let’s say that you and your company contribute INR 25000 towards your Employee Provident Fund (EPF) every year and you put INR 10000 towards a Public Provident Fund (PPF) and INR 20000 towards a life insurance policy premium. That’s a total of INR 55000 that you have pushed into investment instruments. The government loves to see people investing, so they let you have a tax exemption on this amount. Let’s say that you’re in the 20% tax slab (I’ll explain this soon). This exemption amounts to a saving of 20% of 55000 or INR 11000. The maximum amount on which you can claim tax exemption is INR 1.5 lakh. There are many more investment instruments covered by this section and you can check them out here.
80D — Medicals: If you’ve taken out a medical insurance policy, you get an exemption on the premium you pay towards it just like your life insurance premium in the section above. I have medical insurance coverage of INR 1Cr for which I pay a premium of INR 24000 per year. I get a tax exemption on that 24000. Under this section, you can get an exemption on a maximum of INR 25000.
80E — Education and Housing Loans: One day you’re going to have the brilliant idea of sinking tens of lakhs into an MBA or an MS and the only way to pay for that is going to be an education loan with a bank that would charge you anywhere from 7%-12% interest. The Indian government wants you to educate yourself, so they give you a tax exemption on that interest. Let’s say that your monthly EMI on your education loan is INR 30000 of which INR20000 is the interest component and INR10000 is the principal component. You get a tax exemption on the 20000 of interest. The same thing applies to any housing loan that you may decide to take up. This one has no upper limit on how much you can claim a tax exemption on.
80G — This one deals with donations towards charity. I know you’re more likely to spend any spare change you have on a shawarma, so I’m not even going to waste effort here.
80TTA — Interest on savings: You can claim tax exemptions on the meager 4% your bank gives you up to INR 10000.
How is tax calculated?
The government doesn’t levy the same tax rate across everyone. The amount of tax you pay depends on how much of your salary remains after removing the exempted components. This way, you’re categorized into tax slabs with differing rates. The thumb rule is that the higher your income is, the higher your tax rate. There’s been a lot of confusion now that our honorable finance minister has introduced a new tax regime that you can opt for. I find the old regime to save me more money, but I’m going to show you both regimes side by side here.
The first step in this calculation is knowing how much of your income is actually taxable. The way to do this is to use a simple equation:
Taxable income = Total Income - Tax Exempt Components
That’s it. That’s literally it. Take everything you’ve earned that year and subtract all the exempted components that I’ve mentioned above. Here’s what that would look like:
We now have a taxable income of INR 332000. If you refer to the tax slabs in the old regime, this falls into Rs. 2.5–5 lakhs slab attracting a tax of 5%.
Aha! But you have to remember that the tax slabs are additive. What this means, in this case, is that the first 2.5 lakhs are taxed under the first slab (no tax) and the remaining income above 2.5 lakhs is taxed at 5%.
If you had a taxable income of 6 lakhs, then the first 2.5 lakhs would attract no tax, the next 2.5 lakhs would fall in the Rs.2.5–5 lakhs slab and attract 5% tax and the last 1 lakh would fall in the Rs.5–10 lakhs slab and attract 20% tax.
Getting back to our case, this is what the tax calculation would look like:
First INR 2.5 lakhs — no tax
Remaining INR 82000–5% of 56000 which equals a total calculated tax of INR 4100
The government levies a professional tax and a surcharge which I won’t bother explaining here because they’re insignificant.
But hey! You’re a master tax consultant now!
Maximizing tax savings
The easiest way to maximize your savings is to load up on 80C and 80D since they’re actual investments that give you returns while helping you avoid taxes. Any other section needs you to either buy a house or a degree or give money away. I would actually suggest that any employee looking to secure his or her future should look into purchasing life insurance and medical insurance first and foremost. You’re young and you’ll be paying tiny premiums on the policy as a result of your age. Many people jump into stocks and bonds before even looking to insuring themselves and their families. Secondly, look into ELSS which allows your money to be invested in a mutual fund and grow while also saving you tax. These are safe investments that will give you slow, continuous growth that compounds by the time you get around to your late forties.
We’ll talk about financial planning and investments in the next post. For now, I want you to go back and try filing a sample tax form on this website for practice.
