A Comprehensive Guide To Minimize Taxes in Your Investment Portfolio

Taxes – a word that often stirs mixed emotions and questions. So, what exactly are taxes, and why do we hear about them so much?

Well, think of taxes as the contribution we make to our country’s piggy bank. When we earn money, spend it, or make profits from investments, a part of it goes to the government in the form of taxes.

Imagine our country as a big team, and taxes are like the membership fee we all pay to keep things running smoothly. The government uses this money to provide essential services like defense, police, healthcare, and education. They also use it to support sectors like agriculture and assist those in need.

Now, here’s the interesting part – taxes can influence how we behave. Just like in some cities worldwide where taxes shape the growth of specific areas, governments use taxes to guide our actions. It’s a bit like giving us a nudge in the right direction.

While taxes might not bring the joy of a celebration, they indeed serve a crucial purpose in constructing and upkeeping the roads we travel, the schools we attend, and the hospitals that provide care.

Interesting, right? Read through the article to know more about taxes, how they influence our investments, and how to reduce the tax burden of different assets. Let’s get started.

Table of Contents

1.)What Are The Types Of Taxes?

• DIRECT TAX
• How are we Taxed?
• INDIRECT TAX

2.)How is Income Tax Calculated?
3.)How Can You Reduce Your Tax Burden?
4.)How To Lower Taxes On Income And Profit On Assets?

•  REAL ESTATE
•  REITS
• Gold
• Debt
• Equity

5.)IDCW or Growth Option: Which is better?
6.)What Is SWP?
7.)Conclusion

1.)What Are The Types Of Taxes?

There are simply two types of taxes– Direct and Indirect.

DIRECT TAX:

Direct tax is simply charged on your earnings– deducted directly from your income and profits. All types of incomes and profits are included in this list– salaries, fees, rents, interests, dividends, royalties, real estate, stocks, bonds, gold, etc.

As direct tax is completely dependent on your income and profits, the rich people have to pay more tax than the poor. And this is fair because it follows the simple principle– “higher the income, higher the tax.”

How are we Taxed?

In India, the Income Tax is levied on individuals through a slab system, wherein distinct tax rates are allocated to specific income brackets. As our earnings rise, the corresponding tax rates also increase, creating a fair and progressive taxation system within the nation. The income tax slabs undergo periodic revisions, commonly coinciding with each budget session. These slab rates differ for various categories of taxpayers as below.

However, the effective tax rates can vary due to the influence of acess and surcharge. The government also imposes acess to support specific objectives.

As of the financial year 2023–24, an additional 4% education and health cess is imposed in addition to the income tax rate. This measure aims to ensure a higher tax burden for affluent individuals, with those earning more than Rs 50 lakh annually subject to an extra surcharge. The surcharge begins at 10% and escalates significantly to reach 37%, resulting in an overall effective rate of 42.7% for those with an annual income exceeding Rs 5 crore.

INDIRECT TAX:

As said earlier, indirect taxes are charged on the purchases you make. It is not directly levied from your income source but rather indirectly imposed on the goods and services you purchase. A great example of indirect tax is GST. This varies from product to product and is levied upon all the consumers, be it the richest person in the country or the common people.

Alcohol and petroleum are outside the purview of the GST, for a reason only that the government can justify.

2.)How is Income tax calculated?

So here is how our taxes are calculated. This is as simple as it gets.

1. Income Calculation: Different types of income, like salary, house property, business, other sources, and capital gains, are added to get the gross total income.
2. Exempt Income: Certain incomes, like agricultural income, gratuity, and provident fund, are exempt from income tax and are not included in the taxable income.
3. Deductions: Various deductions are applied to reduce the taxable income, like those for investments, insurance premiums, etc.

So, in essence,

Taxable Income=Overall Income-Exempted Income –Deductions

After deductions, the remaining income is taxed at different slab levels. There’s a rebate for those with a total taxable income of Rs 5 lakh or less.

Next is the selection of the Old/New Tax regimes.

So based on this selection our taxes differ as illustrated in the above image.

Ok, now that we have learned to compute tax (at least in the easiest scenario), let’s now get down to the main motive of this article-Reducing the Tax burden.

3.)How Can You Reduce Your Tax Burden?

To lower your taxes, you just have to follow a few simple steps–

• Go for things with no or low GST wherever possible, though this is not feasible in most cases.
• Make yourself aware of all the exemptions, deductions, and rebates like insurance premiums, NPS, NSC, Home loans (if any),Section 80G Donations, just to name a few
• Equity Linked Saving Schemes (ELSS)under section 80C which allows for a deduction of about 1.5 lakh on our gross income, can be smart for taxes, even though you have to keep your money in them for three years.

4.)How to Lower Taxes on Income and Profit on Assets?

A key strategy to significantly cut down on taxes is to choose investments with zero or minimal tax rates. However, it’s essential to note that this doesn’t apply universally, as different investment options come with distinct tax structures.

While we often emphasize diversifying our portfolio to protect investments during market fluctuations, it’s crucial to understand the tax implications of these various components.

How do taxes differ among them, and how can we differentiate between the regular income generated by these assets and the overall profits they yield? Let’s talk about different investment options and taxation.

i).REAL ESTATE:

Did you know that you have to pay taxes on the income generated from rents of real estate properties?

Well, In India, apart from specific agricultural land (What Qualifies as ‘Agricultural Income’?), you pay taxes on real estate rent and profits. But rental income adds to your total income and is, unfortunately, taxed at your slab rate. For example, if your annual income is Rs 30 lakhs and you add Rs 20 lakh in rent from your real estate property, your taxable income becomes Rs 50 lakhs and if it crosses 50 lakhs you may have to the surcharge as well.

Short-Term and Long-Term Profits: Now, if you decide to sell your property, the profit can be short-term (held for two years or less) or long-term (held for more than two years). Short-term profits are added to your income and taxed at your highest slab rate, just like rent. For many readers, this could range between 31.2% to 42.7% in the financial year 2024.

Long-term profits, held for over two years, have a different tax treatment. They are taxed at a fixed rate of 20% of the profit, but here’s where it gets interesting – with something called ‘indexation.’ Indexation adjusts the purchase price for inflation over the holding period, thus reducing your tax outgo.

Ways to Reduce or Eliminate Tax:

Here comes the most interesting aspect.

There are ways to minimize or even eliminate this tax that you just incurred.

• Under Section 54 of the Income Tax Act, if you sell a residential property, buying another residential property with a profit can exempt you from long-term capital gains tax.
• You can invest in Section 54EC bonds issued by specific entities like Rural Electrification Corporation Limited, National Highway Authority of India, Power Finance Corporation Limited, and Indian Railway Finance Corporation Limited. If you invest the profit (up to Rs 50 lakh in a year) within six months of the property sale, your profit becomes tax-free. However, these bonds have a lock-in period of five years. While the interest earned on these bonds is taxable, the principal amount is tax-free when it returns to you.

ii).REITS:

You may also wonder how taxation on the other type of real estate instrument that is gathering steam nowadays- REITs (Real Estate Investment Trusts).

REITs offer a convenient option for investors compared to physical real estate. In terms of saving taxes, they easily beat real estate properties. They are similar to mutual funds, investing in real estate, and generating returns through rent, dividends, and profits reflected in the NAV.

Taxation for REITs differs from physical real estate, with rent, interest, and dividends taxed at slab rates. And if you complete three years, REITs qualify as long-term investment options, with short-term gains taxed at 15% and long-term gains at 10%.

iii).Gold:

Gold – a precious metal, highly coveted and often cherished by the women in our households. Gold can help you generate good profits over a longer time. We can invest them in two forms– ETFs and Index Funds. The thing about gold investment is that it doesn’t give an income or a dividend upfront- just a good profit or a loss.

Physical gold and gold funds become long-term after three years. Short-term capital gains tax is at slab rates for both physical gold and gold ETFs/index funds. Long-term capital gains are taxed at 20% of profit with indexation.

But we are missing another variant here– Sovereign Gold Bonds. Sovereign gold bonds’ interest is taxed at slab rates, and they become tax-free for long-term gains after eight years. They also give a small rate of interest of about 2.5% per year.

iv).Debt:

Debt encompasses all the fixed income products starting from the basic FD, provident funds, PPF, government small savings, bonds, debt funds, and funds of funds (Both Equity and Debt).

• Fixed deposits don’t incur capital gains tax but are taxed at slab rates.
• PF and PPF offer EEE tax benefits, exempting investment, interest, and withdrawals from tax.
• The IDCW option in debt funds adds to income taxed at slab rates. Dividends, once tax-free, are now added to the income and taxed directly.

Before 2023–24, bonds and debt funds qualified as long-term investments after three years. Short-term capital gains were taxed at slab rates, while long-term gains faced a 20% tax rate with the added benefit of indexation.

However, in March 2023, this tax advantage for debt funds was removed, and ever since the debt funds are now taxed as how your FDs were taxed.

With the removal of the indexation benefit from Debt funds, some think they are not tax friendly as FDs. But that isn’t the case.

Apart from the other investment benefits like the SIP, SWP, and partial withdrawals, the Debt funds outscore the FDs when they are evaluated on the following factors

• No TDS in debt funds, unlike the bank FDs where the investor levied TDS when the Interest accrued is greater than 40,000 per year.
• Fixed Deposits, the interest income gets taxed each year as part of the Income from Other Sources. On the other side, when it comes to Debt Mutual Funds, the tax is put on hold until you decide to redeem your units.

So in all phases of investments Debt surpasses the traditional bank FDs. We have this extensively covered in another article of ours on the topic of Debt investment under new taxation. Do read through for a comprehensive understanding of this new rule.

v).Equity:

Equity is a smart choice when it comes to reducing your overall tax charges.

Why?

Because they become “long-term investments” just in a year. And this will let you lower your tax charges to a huge extent.

The Short-term gains are taxed at 15%, while long-term gains, after a yearly profit of Rs 1 lakh, incur only a 10% tax.

If you’ve opted for the growth option in mutual funds, they don’t yield any returns until redemption.

Conversely, selecting the IDCW option in equity funds provides a steady income based on the mutual fund’s discretion. However, this income is added to your account and subject to taxation at your slab rates.

5.)IDCW or Growth Option: Which is better?

The tax implications of the growth option vary between debt and equity products. Starting from FY2023–24, profits from debt are added to income, resulting in the same impact as the dividend option.

On the other hand, equity enjoys an advantage with a mere 10% tax on long-term capital gains. So, in the present tax structure, the growth option takes precedence over the IDCW option for equity investments.

But what if you want an income for your portfolio from your investment option? In this case, you can go for SWP.

SWP magic: How a Systematic Withdrawal Plan can protect your mutual fund portfolio while exiting an SIP

6.)What is SWP?

A Systematic Withdrawal Plan (SWP) enables you to withdraw funds from your investments at predetermined intervals without relying on the fund house to declare dividends.

You have the flexibility to utilize SWP for withdrawing money on a monthly, quarterly, semi-annual, or annual basis as per your preferences. Read this article “An underestimated but unique Investment Strategy” for further information.

7.)Conclusion:

We rightly dedicate considerable time to selecting and evaluating our funds and benchmarking their performance. However, we often overlook the associated tax implications. Being familiar with diverse tax options not only keeps us informed but can also result in substantial savings. The choices made today concerning investment options, growth or dividend preferences, and withdrawal strategies directly influence future tax liabilities.

Therefore, acquiring knowledge about taxes is not merely a wise decision; it serves as a robust foundation for crafting a resilient and rewarding investment plan.

Happy Investing!!!