Tax Fundamentals Every Investor Should Know About
Income tax rules may be confusing, especially when you do not have the right knowledge. However, spending a little time to research may help you understand the basics and plan to maximize profits.
What are some tax fundamentals?
Here are seven fundamental practices that may be helpful:
- Understand how income is taxed
As per the Income Tax Act, 1961 (IT Act), income is classified into five categories, which include the following:- Income from business or profession
- Income from salary
- Income from capital gains
- Income from house property
- Income from other sources
- Within these categories, certain income is exempt. For example, house rent allowance (HRA), leave travel allowance (LTA), and interest income up to a certain limit are tax-free. It is recommended you understand such exemptions for saving tax.
- Invest in the right instruments
It is most likely that you invest to achieve your financial goals, such as children’s education, marriage, and your retirement funds. Several instruments are available for such long-term purposes. It is recommended you choose tax-saving investments, such as equity-linked savings schemes (ELSS), national pension system (NPS), public provident fund (PPF), and others to reduce your liability. - Know the exempt components of your salary
When determining the cost-to-company (CTC), there are certain heads that are tax-exempt as per the income tax rules. Some of these include house rent allowance (HRA), medical reimbursement, leave travel allowance (LTA), travel allowance (TA), and dearness allowance (DA). You must have an idea of these exemptions when determining ways for saving tax. - Determine exit costs
When you invest in different financial instruments to reduce your tax liability, there are certain associated exit costs. Long-term capital gains (LTCG) on equity are taxed at 10% if the total returns go above Rs. 1 lakh per assessment year. However, they have a lock-in period of 12 months. On the other hand, short-term capital gains (STCG) on stocks are taxed at 15%. If you exit debt funds before three years, STCG is included in your income and taxed as per your slab. LTCG tax on debt funds is 20% after indexation. Similarly, if you sell a property, you have to pay taxes as per Section 54 of the IT Act. It is recommended you understand all these costs before making any decision. - Make charitable donations
In addition to tax-saving investments, you may donate to charitable organizations to reduce your tax liability. Section 80G of the IT Act offers tax benefits on charitable donations to eligible organizations as per the rules. Either 50% or 100% of the amount may be eligible for tax benefits as per the provisions of section 80G. Knowing about these provisions beforehand is advisable. - Build a plan
Tax planning must be a year-round process. You may use your last year’s income tax return (ITR) as the base of your planning procedure. First, you must determine the approximate taxable income before you look for ways to reduce your liability. The plan must also include your financial goals because the investment horizon is an important factor while choosing different types of instruments. - Seek professional advice
If you find the entire procedure of tax planning and understanding the various rules and regulations overwhelming, consider seeking professional advice. An experienced professional will look into all aspects of your income, expenses, financial goals, and other factors to provide the most efficient plan. He/she may also offer investment recommendations and structure your salary in a way that reduces your tax liability without facing any financial difficulties. However, before you hire a professional tax advisor, you must research about different service providers. Reading reviews and feedback offered by past clients will be beneficial in understanding their service quality. You may also ask your friends and relatives for recommendations.
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