Gifting money to family members can cut the liability on interest income.
With the stock market indecisive and income plans of mutual funds hit due to the tightening of interest rates, investors have been increasingly turning to bank fixed deposits (FDs) as a safe shelter.
As bank interest is fully taxable (thereby reducing effective yields), the rationale for preferring FDs over other investments seems primarily to ensure security of the capital, rather than earning a high return. However, effective tax planning can help you get the best out of FDs too.
For this, we first need to familiarise ourselves with two concepts of income tax. The first is your basic income tax threshold. The first Rs 1.6 lakh of income is exempt from tax for men. For women who are not senior citizens, the limit is Rs 1.9 lakh. For senior citizens (65-plus), the limit is Rs 2.4 lakh.
The second concept works hand in hand with the first. It is known as Section 56 of the Income Tax Act. It basically exempts cash gifts between relatives. Though there is a long list specified in the section, for our purposes it suffices to know that you, your parents, your brothers and sisters and your children are all relatives of each other.
To understand how these two tools can be used for some smart tax planning, let’s take the example of Hiten Shah, 49. He’s in a senior management job, which puts him in the highest tax bracket. He has retired parents, who live with him. His wife is a home maker. They have a son, 20, and a daughter, 18.
Shah, though keen on investing in FDs, is not happy about the tax aspect. Being in the highest bracket, he finds an eight per cent pre-tax rate ultimately ends up earning him just 5.6 per cent after tax. It was at this juncture that Shah was introduced to our strategy by an old chartered accountant friend.
He gifted Rs 30 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 eight per cent yearly. Which meant each parent earned Rs 2.4 lakh as interest from the FD (eight per cent of Rs 30 lakh). However not a paisa of this was taxable, as it is not beyond the initial tax slab available to senior citizens.
In one stroke, Shah, effectively made income from Rs 60 lakh of capital tax-free in the family’s hands. Realise that had he 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.
He then finds his children have some time to go before they start earning. His daughter can earn up to Rs 1.9 lakh without having to pay tax and his son can similarly earn Rs 1.6 lakh. But they aren’t earning; they’re studying and will continue to do so for the next five to seven years. So, what does he do? He gifts them Rs 23.75 lakh and Rs 20 lakh, respectively. This money, in turn, is invested in a similar bank FD by the kids, thereby earning Rs 1.9 lakh and Rs 1.6 lakh, respectively. As explained earlier, no tax would be payable.
In effect, by using two simple tools the Income Tax Act offers, Shah had managed to make Rs 8.3 lakh of income, completely tax-free, for the family. Putting it differently, over Rs 1 crore of capital was deployed, but the income thereon was totally tax-free.
Note carefully that it is not income of Rs 1 crore that is rendered tax-free. It is the income on a capital of a crore (Rs 1.0375 crore, to be precise) that is sought to be made tax-free.
Not everyone will have this kind of money. 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.
Also note that his profile was of a man working in the highest tax bracket, with retired parents having no income of their own, and two adult children who are still studying. Again, not every taxpayer will have a similar profile. You father may be having taxable income but your mom may not be working. Or your children may be earning already. However, the idea is to use that particular element in the equation which applies to your situation directly.
The writer is director, Wonderland Consultants
