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Opt for deductions or lower tax rate?

The new option you have, is to forgo all these deductions and exemptions to pay tax on your income at a lower rate. The rates have changed up to an income level of Rs 15 lakh. Beyond that the income tax rate remains at 30%.

The Union Budget 2020 has proposed allowing individual tax payers to choose how they would like to be taxed. Till now, there was a single route to income tax; you received your salary or professional fees, accounted for deductions, exemptions and expenses (for professionals) and paid tax on whatever was left over. 

The new option you have, is to forgo all these deductions and exemptions to pay tax on your income at a lower rate. The rates have changed up to an income level of Rs 15 lakh. Beyond that the income tax rate remains at 30%. 

While a lower income tax rate is tempting, don’t be in a hurry to let go of your deductions, especially the ones that help you create long term wealth. 

Deductions that helped you

Under Sec 80 C of the Income Tax Act you can invest an amount up to Rs 1.5 lakh each year and this investment is considered as a deduction from your taxable income. The eligible investments within this Sec 80 C include your provident fund contributions, life insurance premium and ELSS tax saving mutual funds. 

ELSS not only helps you save tax but also, remaining invested in equity assets over 5-10 years and longer helps in growing your wealth exponentially. It’s a means to save and invest towards long term wealth creation. Popularly known as tax saving mutual fund schemes, ELSS comes with a three-year lock in, which ensures that you build a discipline of remaining invested rather than redeeming to fund short term expenditures. 

These attributes of ELSS, makes it a good tool to get an immediate short-term benefit of tax saving and a long-term benefit of wealth creation. 

This means that despite the lower slabs of income tax rate in the new option, you will end up paying more tax rather than less. Plus, you would have forgone a good long-term investment option. Similarly, if you earn Rs 20 lakhs a year, assuming Sec 80C deductions to be the only ones you claim, under the new option you will end up paying additional tax of Rs 54,600.

What happens if you forgo the deduction for lower tax?

Let’s assume you earn Rs 10, 00,000 per annum. Under the new option for income tax calculation, you will end up with a tax payable of Rs 78,000 without including any deductions and exemptions. Under the old system, if we include Rs 1,50,000 invested in ELSS as the maximum deduction under Sec 80 C, the only deduction you are claiming, then your tax payable comes to Rs 75,400. This is a simplistic example as it does not consider exemptions like House Rent Allowance or housing loan interest deduction or NPS deduction, even so the tax payable is lower. 

This means that despite the lower slabs of income tax rate in the new option, you will end up paying more tax rather than less. Plus, you would have forgone a good long-term investment option. Similarly, if you earn Rs 20 lakhs a year, assuming Sec 80C deductions to be the only ones you claim, under the new option you will end up paying additional tax of Rs 54,600.

Purely from a tax saving perspective, there is no benefit in forgoing the deduction currently available for investing in funds like ELSS. As an individual, you will lose out not only by paying more tax but also by leaving out crucial long-term investment required for your future financial goals.

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