I define live taxation planning as planning the actions that could reduce taxation. This is distinct from dead taxation planning where at the time of filing your taxation returns you examine your actions, including investments, and pay tax without the ability to alter anything.
What you have invested in, category of returns and when you withdraw have considerable impact on your cash flows and post taxation returns. Hence, not knowing the taxation rules of various asset classes can be detrimental.Taxation is beneficial to examine your income in a holistic wealth management perspective, where total income is sum of active and passive income. For most people, active income is salary while passive income (defined as anything not being generated from active employment) includes rent, interest income, short and long-term capital gains, dividends and royalties. The government taxes active income and then, through taxation, links it to your passive income. It uses this as a tool to motivate you to save and channelise savings in productive areas of economy.
For example, section 80C reduces your taxable income up to Rs 1 lakh and, therefore, saves Rs 30,000 in taxes, if in 30% tax bracket. One can invest in designated saving instruments, including national savings certificates, provident fund, insurance schemes, equity-linked savings schemes and home loan repayments. Additionally, deductions for higher education, charitable purposes, and medical insurance and house rent can result in significant savings.
For passive income, various asset classes are taxed in various ways. Just to illustrate, capital gains for equities are considered to be long term if you have held it for more than a year; long-term capital gains tax is zero while short term is taxed at 15%. For real estate, capital gain is long term when you hold it for over 3 years. For different debt funds, there is multiplicity of tax rates. Even options like dividend and growth have different rates.
Importantly, the government is introducing direct taxes code (DTC) effective April 1, 2011. The crux is simplification by removing distinction among active and passive income. Income slabs will be made wider, up to Rs 10 lakh might be taxed at 10%, from Rs 10 to 25 lakh at 20% and above Rs 25 lakh at 30%.
Interestingly, it aligns nicely with a major wealth management concept of maximising human economic resource value from both active and passive means. Further, it simplifies matters by removing multiplicity of differing rates.
DTC will classify investments as EEE and EET (E is exempt, T is taxation and three timing stages are investment, accruals and withdrawal). EEE investments are not taxed at all while EET investments are taxed at the withdrawal stage. EEE products will include PF, pure insurance schemes, annuity products and NPS. Ulips and ELSS might be designated as EET.
Under section 80C, tax deduction might be raised to Rs 3 lakh. Within the basket of products, permissible under this section, some might be EEE while some EET. EEE products, being retirement products will carry restrictions on withdrawals and composition (for example, equity component in NPS can not exceed 50%). Also, when an investor is 60 years old, 40% of NPS accumulation will have to be invested in an annuity. EET products might not have such restrictions, but suffer from taxation on withdrawal. Consequently, investment selection will be optimised on a tantalising trade off between attractive taxation, freedom of asset allocation and liquidity.
The linkage between investments and taxation will be much deeper under DTC. Selection and timing of profit-taking for an investment will considerably affect the taxation for that year. Consequently, Live Taxation Planning will be of paramount importance.
?The writer is founder of http://www.financedoctor.in