Here's how to make income on Rs 70 lakh tax-free!

Have you noticed ELSS (equity-linked savings scheme) funds are being launched left, right and centre? That insurance companies, not to be left behind, are busy with their single premium, multiple premium and premium back ULIP offerings? That financial dailies are awash with fixed deposit ads offering tax breaks?

Just like mangoes appear in summer, these products tend to emphasise their presence in and around December. For December is tax-planning season: a season when investors wake up to the rather unpleasant, but necessary, task of making investments to save tax.

But if you ask me, this is too much ado for a paltry Rs 30,000. And look at the number of products competing in the same space -- bank deposits, mutual funds, ULIPs (unit-linked insurance products), life insurance products, PPF, NSC and pension plans -- all vying for the aggregate limit of Rs 1 lakh (Rs 100,000) offered by Sec. 80C of the Income Tax Act. And this is not even considering mandatory cash flows like employees provident fund, home loan installments and children's tuition fees.

Which means that the maximum tax most people can save is Rs 30,000. Period.

If you happen to be in the highest tax bracket of 33 per cent, the amount is marginally higher at Rs 33,600. The lock-in period that the tax saving brings in its wake is another irritant. PPF (Public Provident Fund) or NSC (National Savings Certificate) means locking your money for six years. ELSS and ULIPs offer a marginally lower lock-in of 3 years, but you take equity risk with your hard earned money.

'No exit route' in an equity investment is not everyone's cup of tea. And most of all, the 30-odd thousand is hardly going to make a dent in the tax outgo for most investors.

So what's the solution? Does one be a mute spectator and accept the inevitable?

Well, perhaps not. In this article, we are going to discuss two tools that if used optimally can save you heavy taxes. Both when used simultaneously create such synergy in tax savings that it is really mind-boggling. Read on to know more.

The first tool is your basic tax threshold. Readers would know that the first Rs 1 lakh of income is exempt from tax. For non-senior ladies, the limit is Rs 135,000. And for senior citizens (65-plus) the limit is Rs 185,000.

So far, so good.

The second tool that works hand in hand with the first is known as Sec. 56 of the Income Tax Act.

Sec. 56 basically exempts cash gifts between relatives. Although there is a long list specified in the section of what constitutes 'relatives,' for our purposes, suffice it to know that as per the Income Tax Act, you, your parents, your brothers and sisters as well as your children are all relatives of each other.

Now in order to understand how these two tools can be used for some smart tax planning, let us take the example of one Mr Mehta who is 49 years of age.

He happens to be 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. And he and his wife are also proud parents of an 18-year-old daughter and a 20-year-old son who are both studying in college.

Read Mr Mehta's profile once more if you must because it is important in our scheme of things. Also remember that some of the numbers that are going to be thrown up are astonishingly large. Don't get thrown off because of that.

This is just the power of these tools at work. You can use them at any income level to suit your particular situation. What is important is understanding the concept. . .  individual numbers can always be plugged in.

Now Mr Mehta, like most of us, finds that all the tax saving investments in the world can help him save only Rs 33,600. That's not enough. His tax outgo is much more. Moreover, every rupee of post tax paid income that he invests in, say, RBI Bonds, Bank fixed deposits, Post Office MIS, et cetera, is subject to the highest rate of tax.

If he doesn't want to pay tax, he is forced to adopt market risk by investing in equity shares or mutual funds as long-term capital gains are tax-free. But this was hardly a solution.

He has found the stock market to be too whimsical for his liking -- while it gives a reasonably good return for a period of time, it also suddenly falls by around a 1,000 points in a couple of days. Already suffering from hypertension, no beta blocker in the world could prevent his pressure from outswinging the market.

It was at this delicate juncture that Mr Mehta was introduced to our tax planning tools by an old chartered accountant friend of his. This is what Mr Mehta did after his brief, but illuminating, chat with his friend.

He gifted Rs 21.25 lakh (Rs 2.125 million) to his father and a similar amount to his mother. Out of the gifted money, his father invested Rs 15 lakh (Rs 1.5 million) in the Senior Citizen Savings Scheme (SCSS). The balance Rs 6.25 lakh (Rs 625,000) was invested in RBI Savings Bonds.

His mother did the same.

Now what happened was the following. The SCSS yielded an interest of Rs 135,000 (9% of Rs 15 lakh). The RBI bonds yielded a return of Rs 50,000 (8% of Rs 6.25 lakh). The total interest earned by Mr Mehta's father was Rs 185,000. His mother too earned a similar amount.

However, not a penny of this was taxable as it is not beyond the initial tax slab available to senior citizens.

In one stroke, Mr Mehta, effectively made income from over Rs 42 lakh of capital tax-free in the family's hands. Realise that had Mr Mehta 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.

Now, Mr Mehta finds that his children have some time to go before they start earning. His daughter can earn up to Rs 135,000 without having to pay tax, while his son can earn Rs 100,000 without having to pay tax. But they aren't earning as of now, are they? They are studying and will continue to do so for the next five to seven years.

So what does he do? He gifts them around Rs 17 lakh (Rs 1.7 million) and Rs 12.50 lakh (Rs 1.25 million), respectively. This money in turn they invest in the 8% RBI Bonds. Rs 17 lakh earns Mr Mehta's daughter around Rs 135,000. Of course, as explained earlier, no tax would be payable. Now you can work out the math for yourself in case of Mr Mehta's son.

In effect, by using two simple tools that the Income Tax Act offers, Mr Mehta had managed to make almost Rs 6 lakh (Rs 600,000) of income tax-free for the family. Putting it differently, over Rs 71 lakh (Rs 7.1 million) of capital was deployed, however, the income therefrom was totally tax-free.

Now admittedly, Mr Mehta is an extremely rich man. He had Rs 70 lakh (Rs 7 million) to spare in the first place before trying to make it tax-free. Not everyone will have this kind of money.

However, 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. In other words, it is not an all or none strategy. . . use it to the best of your ability.

Also note that Mr Mehta's profile was an ideal one. A man working in the highest tax bracket with retired parents having no income of their own and two major children who are still studying. Again, not every taxpayer will have a similar profile. You father may have income of his own, but your mom may not be working. Or your children may be earning already. However, the point is to use that particular element in the equation which applies in your case directly. The rest can't be helped.

Note that we have left Mr Mehta's home maker wife out of the picture. There are reasons for this -- the Act specifies that any income earned out of money gifted to spouse is added back to the donor's income for tax purposes. There are ways out of this too, but that is the topic for another column.

Last point

Beyond a point (barring ideas such as discussed above), tax saving is not possible. The worst mistake any investor could make is to invest with the primary objective of saving tax. The question to ask is would you have made the investment if it didn't offer tax saving? If the answer is no, don't touch the investment. It is better to try and optimise post-tax income instead of making a sub-optimal investment just to save on tax.

Or like Donald Trump says, some of your best investments are the ones that you don't make.

The writer is Director A N Shanbhag NR Group, a tax and investment advisory firm. He may be contacted at sandeep.shanbhag@gmail.com