India - Income on Rs 78lakh can be tax-free

Sandeep Shanbhag

Here’s how someone in the highest tax bracket could do this

With the stock market expected to continue being choppy and fixed income plans of mutual funds battered under credit concerns as well as interest rate swings, investors have been increasingly turning to bank fixed deposits (FDs) as a safe shelter for their money.

As bank interest is fully taxable (thereby reducing the effective rate), the rationale for preferring FDs over other investments seems primarily to ensure security of capital rather than earn a high return.

However, there are ways the investors can jack up the return from their FDs. Last week, we examined how tax-saving FDs can potentially earn a rate of 16.67% p.a.

This week, we shall reexamine a strategy that can optimise the effective rate of your FD. Though this subject has been dealt with in a past column, the current environment definitely warrants a relook.

Let us familiarise ourselves with two concepts of income tax before we set off.
First is the basic threshold. Readers would know that the first Rs 1.50 lakh of income is exempt from tax. For non-senior ladies, the limit is Rs 1.80 lakh and for senior citizens (65 plus) the limit is Rs 2.25 lakh.

The second concept, which works hand in hand with the first, pertains to Sec 56 of the Income Tax Act, which 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 Income 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.

His wife is a homemaker and they are the proud parents of an 18-year-old daughter and a 20-year-old son who are both studying in college. Mehta’s retired parents live with them.

Read 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 the tools at work.

You can use them at any income level to suit your particular situation, as long as you understand the concept, individual numbers can always be plugged in.
Mehta, though keen on investing in FDs, is not too happy about the tax aspect. Being in the highest tax bracket, he finds that a 10% pre-tax rate ultimately ends up earning him
just 6.6% after tax.

It was at this juncture that Mehta was introduced to our strategy by an old chartered accountant friend of his. This is what he did after a brief but illuminating chat with his friend.

He gifted Rs 22.50 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 10% p.a. This basically meant that both his parents earned Rs 2.25 lakh as interest from the FD (10% of Rs 22.50 lakh). However, not a penny of this was taxable as this was not beyond the initial tax slab available to senior citizens.

Thus in one stroke, Mehta effectively made income from Rs 45 lakh of capital tax-free in the family’s hands. Realise that had 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, Mehta finds that his children have some time to go before they start earning. His daughter can earn up to Rs 1.80 lakh without having to pay tax and his son can similarly earn Rs 1.50 lakh. 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 18 lakh and Rs 15 lakh, respectively. This money is in turn invested in a similar bank FD by the kids, thereby earning Rs 1.80 lakh and Rs 1.50 lakh, respectively.

Of course, as explained earlier, no tax would be payable. In effect, by using two simple tools that the Income Tax Act offers, Mehta had managed to make Rs 7.80 lakh of income completely tax-free for the family.

Putting it differently, as much as Rs 78 lakh of capital was deployed, however, the income there from was totally tax-free.

Note carefully that it is not Rs 78 lakh of income that is rendered tax-free; it is the income on a capital of Rs 78 lakh (Rs 7.80 lakh) that is sought to be made tax-free.

Admittedly, Mehta is an extremely rich man. He had Rs 78 lakh 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 Mehta’s profile was an ideal one - that of a 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. Your father may be having taxable income but your mother may not be working. Or your children may be earning already. The idea is to use the particular element in the equation which applies to your situation directly.

There is a way to further refine the strategy outlined above, as suggested by Mr Meswani, a reader, when this topic was discussed earlier. Each recipient (both parents and the two kids) can potentially be given a further Rs 10 lakh each. At the rate 10%, this will result in an extra income of Rs 1 lakh, which in turn can be invested in any Sec 80C instrument such as PPF, NSC, etc.

This way, a further Rs 4 lakh income or Rs 40 lakh of capital can be sought to be made tax-free. Added to the earlier Rs 78 lakh, this means Mehta and his family can earn tax-free income on a capital of over a crore!