Filing your returns this week? Show taxable income properly

First the good news – due to certain problems with the IT E-filing site, the deadline for filing IT returns have now been extended till August 5th. So, if you were one among the many who were late, you can still go ahead and file your returns now. While the penalty for filing delayed returns is only from next year, there are important reasons why you must do it on time. It is the right thing to do, you have a chance to rectify it if required, your refunds get processed quicker.

It is important to understand that you need to account for ALL income when you are trying to arrive at your taxable income in a Financial year. In fact, some of these incomes may well be exempt from taxes but it still needs to be declared in the form. In the terminology of Income tax, there are 5 heads in which you need to categorise your income. These are as follows:-

  • Salaries
  • House property
  • Profits or gains from Business or Profession
  • Capital gains
  • Other sources

Let us look into these income sources one by one. For most people filing tax returns, salaries are the bulk of their income. This will be your source, if you are employed by a company or business or another individual and get paid for your time. It does not matter whether you work full time or part time, as long as there is an Employee – Employer relationship, the income can be classified as salaries. When you need to give data for your tax filing purpose, note the following :-

  • Your Employer has to give you Form 16 which will record the total salary paid including the monetary value of perks, exemptions allowed for different allowances like HRA and Transportation, Exemptions under 80 C, 80 D etc.
  • The Form 16 also shows the total tax deducted as TDS and the tax liability. This is why some people think that is enough for tax return filing. However, this is not true as you will be having other sources of income in most cases.

Income from House property is relevant if you own one or more house property. You need to remember the following while filling up this schedule:-

  • Even if you are staying at the house, it still needs to be documented in the ITR returns. For self occupied houses the income will be nil.
  • If the property is rented you have to show the actual income from it. Many people think that for a single house there is no need to declare income – this is completely incorrect and you must never get into this.
  • Standard deduction on income is at 30 % and you can also charge for any taxes or other regulatory expenses incurred in the house.
  • Interest can be charged up to a maximum of 2 lacs per house.
  • After all these deductions from rent received during the year the total income from House property will be calculated.
  • If you have a single house and it is not occupied by you and not rented out, then you can take the income as nil.
  • If you have 2 or more properties there will be a deemed income from all other properties except the first one, even if none of them are rented out.

Most salaried people earlier did not have any income from business or profession but it is becoming more commonplace now. There are of course, many others who do not have a salary but have income from business or profession. While looking at income from this head, you need to keep the following in mind:-

  • If your Business turnover is more than 2 crores or your professional income is more than 50 lacs, you will need to maintain a set of Accounting books and these will have to be audited as per laid out procedure.
  • For others the business income can be taken to be 8 % of gross receipts in business and return filed accordingly.
  • For professionals with less than 50 lacs gross receipts, you can charge 50 % expenses and take the rest as income.
  • In case you are showing income on presumptive basis, as in the above 2 cases, you will not be able to charge any other expenses to the business.
  • If the above does not work well for you, there is always the option of maintaining books, getting them audited and filling up the returns in a more complex manner.
  • For example, if your business turnover is 1 crore but your profits have only been 2 lacs, you will have to maintain books and proceed accordingly.
  • For a professional earning 40 lacs but having 30 lacs as business expenses, it will again make sense to maintain books and show only 10 lacs as income.

Capital gains can arise out of the sale of any asset such as Real estate, gold, Equity, Debt etc. The important things to be kept in mind are as follows:-

  • Short term capital gains are added directly to your income, Long term capital gains will get indexation benefits.
  • For equity LTCG requires holding period of 1 year and is tax exempt. So if you sell your shares after holding them for a year, you do not need to pay taxes on your capital gains. However, you do need to report it.
  • For debt LTCG is applicable after 3 years of holding and indexation benefits are there. The tax on the Capital gain post indexation is 20 %.
  • In order to save on Capital gains you can put the gains in Capital Gain bonds.
  • For real estate, as long as you invest the capital gains to buy something new it will not be taxed.

Other income is literally everything else from dividends, interests, lottery earnings, winnings from horse races etc. Some common mistakes people do are as follows:-

  • Where TDS is not deducted at all, such as in Post Office MIS, you must declare the interest as taxable income.
  • Where 10 % TDS is deducted as in Bank FD, you must again declare the total interest earned. 
  • Even if no TDS is deducted as you have given form 15 G / H to the bank, the interest earned by you must be declared.
  • Interest exempted from taxes such as interest from Tax free Bonds etc need to be shown too at the appropriate locations.
  • Dividends are again tax free in your hands but need to be shown.

I hope with this you will be able to get all your income recognised correctly. After this you will need to look at taxes paid and if any other liability is there still. We will take this up in the next post as this is already too long.

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My 2016 Income audit

As I had said in an earlier post, my expense audit of 2016 showed that it was by far the most expensive year of my life yet. This was somewhat unexpected as my initial idea was for Rinki to either take up a job or to get her B school education funded entirely through an Educational loan. In the actual event, I decided to fund her first year expenses and with several other discretionary expenses adding up, we ended up spending what we did.

While I have not been worried about the figure as it is not really representative of our future expenses, these still needed to be funded from somewhere. When I looked at the income sources from 2016, I was happy to see that I was able to take care of the significant higher expenses through my income and other planned sources, without having to take recourse of redeeming my investments in any unplanned manner. Not that it would have mattered a great deal but it is good to know that my current portfolio can withstand the shock of significantly higher expenses relatively well.

Let me state upfront that this was possible due to the fact that I had some active income in 2016. Of course, I worked full time only in January and then again from June to December part time. If you look at the overall time spent, it would have not been more than 25 % of normal working. In other words if the normal working days in a year are about 220 full days, I probably worked for 55 full days. As my earning out of it was more than 30 % my likely earning should I have worked full time, I guess I was quite productive.

My passive income is through multiple sources and will normally be able to take care of my expenses comfortably. A closer look at the passive income stream in 2016 reveals the following :-

  • Rent from the Chennai apartment was along expected lines and covered up our rent paid in Hyderabad, with a little to spare.
  • Interest from tax free bonds amounted to 2.16 lacs as planned.
  • FMP investment of 26 lacs were redeemed in the year. I have reinvested the principal amounts while using the capital gains as passive income. Amount of capital gain was equal to roughly 7 lacs in the year.
  • Dividends from stocks and some Mutual funds amounted to about 5 lacs in the year.

As far as the educational expenses for children went, I had planned it through some FD in their names which are outside of my net worth calculations. It was fortunate that this was planned liberally and I was able to use some of it for Rinki’s B school expenses. The rest of it was funded through my active and passive income. This will not be there next year as we plan to fund the rest of the XLRI fees through the sanctioned Educational loan from SBI. Ronju will still have 4 semesters to go in BITS, so we will have to pay through 2017 and 2018, but these are already planned for.

In overall terms despite serious changes in plans the expenses were managed through the income generated. By the way it looks, next year should be a lot better in terms of surplus money available to invest more. Realistically, 2018 will probably be the year when I can do without any active income at all.

Tax compliance – most people live in glass houses

This post is going to be politically incorrect and many will view it as a harsh indictment on most people. However, it will also be the complete truth and as usual, I do not care much about public opinion when I am writing these posts. Now that you have been given an early warning and have had a chance to stop reading, let me get on with it.

As all of us know there are only about 4.5 crore people in the country today who file their tax returns. This too is after a great deal of efforts by all relevant authorities, the figure used to be less than 2.5 crores only about 5 years back. Now out of this 4.5 crores there are many who pay no taxes, so the number of tax payers is only about 2.5 crores. Among these also, the number of people paying taxes less than 10000 Rs is significant. Now, it does not take a genius to figure out that there must be tax evasion on a massive scale here. Also, even the people who are paying taxes are probably not fully compliant.

Why do people, who are perfectly well educated and understand the importance of taxes do not take the right attitude of paying taxes. Well, the harsh truth is they want to keep the money themselves due to their wanton greed and crooked nature. However, since they cannot take that stance publicly, due to their own image and the inordinate fear of tax authorities, they will come up with several excuses that sound reasonably clever but are completely flawed in reality. Let us look at some of these :-

  1. Our tax rates are too high, cannot afford to pay so much. Yes, this used to be true decades back but the current rates are quite reasonable.
  2. Tax laws are too complex, do not want to get into it. Truth is that arriving at your taxable income and taxes is fairly simple and you have a slew of professionals who can help you with it.
  3. Taxes paid by me will not be used properly. This may or may not be true, but it cannot be a justification for not paying taxes.
  4. Chances of getting caught are not high. People giving this logic are of course admitting that they want to stay crooked as they probably will escape.
  5. Even after paying taxes I will be harassed by the tax authorities. Truth is only 1 % returns get taken up for scrutiny and that too if there are some red flags in them.

So who are the people who practice tax evasion on a massive scale? Almost all sections of society and some of the notable ones are as follows:-

  • Professionals like Doctors, Lawyers, Consultants, Architects who insist on getting paid by cash, maintain 2 sets of books and seriously under-report their income while seemingly being tax compliant citizens.
  • Small businesses which deal almost entirely in cash, have very little records and almost pay minimal taxes or no taxes.
  • Individual vendors like a Chaat wala or a Fish seller who are of course not in the tax ambit at all. Now, I have my full sympathy for their plight in life, which is tough to say the least, but as far as taxable income goes they need to file returns if their income crosses the threshold of 2.5 lacs in a year.
  • Small companies and big corporate who have stretched the tax laws to the limit, often quite creatively, to ensure their employees can avoid taxes as much as they can.
  • Individuals who rarely report the right income in terms of House property and other financial assets.

What about the people who do pay taxes more or less correctly? Well, firstly their numbers are really pretty limited, most of them are salaried people who can limit the TDS but cannot really avoid it. However, even here there are serious mistakes or malpractices that are common. Let me state a few of them :-

  • Many people getting rent from a house owned by them so not declare it properly. Some under-report it, some believe that for one house the rent does not need to be declared, some show the house as self occupied etc. The rule is very clear, any income you earn must first be reported, exemptions can be looked at later.
  • This is more tricky, but the law is that if you have 2 houses you need to declare some deemed rent for the second house and add it to your income. It does seem frightfully silly but if it is the law then it has to be followed.
  • Most people do not declare income from their Debt instruments such as POMIS etc where there is no TDS provision. The logic again is that it will be difficult for the tax authorities to find out !!
  • For FD where there is TDS, very few people declare the total interest income and pay the taxes beyond the statutory deduction of 10 %.
  • As far as LTC and Medical bills go the malpractices are quite legendary and most readers will be familiar with them.
  • Capital gains earned are often not reported at all or reported wrongly.
  • Savings bank interest are now exempt till 10000 Rs but all such interest earning must be declared and applicable taxes paid on the amount exceeding 10000 Rs.

Are you seeing anything here that you can identify with? If so, I would seriously suggest that you correct this when you are filing your returns next year. Do not listen to people telling you as to how you can avoid taxes, they are crooks of the first order. You should pay taxes properly because it is the right thing to do, not because you can get caught. In any case, with the IT enabling of records, it will become increasingly difficult not to be tax compliant, so you might as well make a virtue out of a necessity.

Not paying taxes due is a sure shot indicator of being a bad citizen. You can pay your dues and then question the government as to how it is using the taxes. They are accountable to you, just as you are accountable to the tax authorities.

Building a passive income stream from scratch

This post is inspired through a discussion I had yesterday with a long time friend. He is considering to get out of his current corporate job and wanted to set up a passive income stream that will take care of his regular expenses. When I pointed him to my posts on this topic he said that, while he had read those posts and understood the situation from my context, he needed to set this up from scratch.

The discussion set me thinking and I wanted to look at a situation which many people may be facing when they are nearing retirement or are considering an early retirement. While generalization is always difficult, a typical situation of such a person may be as follows.

  • The person has an own home which is fully paid for by now.
  • He has a PPF account for a long time but has not contributed the maximum in a regular manner. Current balance in the account is 24 lacs (say).
  • His children are either independent or in college. In the latter case he has made arrangements for the remainder of their education expenses through FD etc. This is not linked to the passive income that he wants to have.
  • Fixed deposit amount is 20 lacs, PO MIS is 9 lacs in a joint account.
  • PF and gratuity will come to 1 crore when he withdraws it.
  • MF portfolio is 20 lacs and stock portfolio is 6 lacs.

Based on this, how should the money be deployed so as to get a passive income of about 7 lacs a year? There may be many ways but the framework suggested below is a good one:-

  • Keep the current MF and stock portfolio intact for the long term. You may need it for situations such as long term care, beyond the age of 80.
  • New investments in PPF are not needed but keep the account active by paying a small subscription every year. This is your fall back mechanism if you suddenly need money for some unforeseen event. Also the interest of 2 lacs a year is tax free.
  • 9 lacs of PO MIS will give an interest of 75300 every year. Use this for your income.
  • FD of 15 lacs can be put in Senior citizen scheme if you are eligible. The interest from this will be about 1.35 lacs.
  • Divide the 1 crore obtained from PF and gratuity as follows:
    • 30 lacs in tax free bonds. This will give you an income of 2.3 lacs per year.
    • 30 lacs in some dividend paying debt scheme such as Monthly Income Plan or Balanced funds. This will give you an income of 2.4 lacs odd.
    • 10 lacs in a Liquid fund. Income from this will be about 70000 a year.
    • Rest 30 lacs can be put in FMP or other Debt MF (short term) in the Growth option. After 3 years you can use the capital gain for consumption and reinvest the principal amount. This is mainly for discretionary expenses such as a vacation abroad etc.

What about inflation? Well, you have enough hedges in the plan for that. PPF can be drawn into, LTCG from FMP or debt funds are there and equity part will hopefully grow. Also over a period of time the 7 lacs needed in current terms may not suffer as much from inflation as we think. However, even if it does, the plan above is likely to cover it.

Note that the above is a low risk plan where your passive income is pretty much assured. Other options where you put more money into equity are possible but they come with a higher risk. You do want peace of mind when you are at this stage in life!!

So with an overall asset base of 1.79 crore (plus house), you can comfortably generate a passive income of 7 lacs and take care of the future also. I hope this convinces people that you do not necessarily need 5-6 crores to have a decent retired life. More importantly, you can lead the life you need to lead at the right time for yourself and your family.

An asset base of even 1.5 crores, deployed creatively, may well be enough for this person to retire. Take this framework as a reference and arrive at your own plans for that.

Tax free bonds – Who should invest?

Many of you may be knowing that 7 PSU’s are  going to come up with Tax free bonds in the market very soon, maybe starting late July itself. The total value of these bonds are going to be 40,000 crores and the tenure will be 10, 15 and 20 years. The interest rates are likely to be in the range of 8 %, maybe a little less.

There is a lot of interest among investors for the tax free bonds and it is likely to be fully subscribed. The last time they were available in 2013-2014, the bonds were quite successful and even today these sell at a premium in the secondary market. For investors the big question is – should you be investing in these? Before getting into that let us see what are the benefits and drawbacks of the tax free bonds.

  • You are able to lock in your funds at a reasonable interest rate and get tax free money every year.
  • Liquidity of the product is poor as selling in the secondary market will not be easy.
  • Due to the long  lock in you may lose out on rising interest rates at a later date.

This is clearly not a product for wealth creation as the growth will be limited to real returns of 1-2 % or so. The basic attraction of the product is safety of capital as well as tax free income. People who are in the tax brackets of 10 and 20 % may not find much value in this as the lock in periods are rather long.

I think you can look at investing in these bonds if you are an investor with the following characteristics:-

  • You are i.n the 30 % tax bracket and are looking at tax free income.
  • You are trying to set up a passive income stream and want regular and assured income that is tax free.
  • You have got a retirement corpus and want to put part of it in instruments that generate assured and tax free income.
  • You have a long term commitment of an amount and you are looking at a simple means of generating it year on year.

For people in the accumulation and growth phase of their investments, this is not a right product. Invest in financial assets like stock or Mutual Fund which will have higher growth potential. Even for debt option choose products that are liquid.

People looking at long term, regular, assured and tax free income will find this to be an ideal product.

Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.

Equity as an asset class #9 – Styles of investing

Now that we know it is a good thing to invest in equity as an asset class, let us try and understand the styles of investing. Note that I am talking about basic styles in purchasing, holding and selling, not stuff such as futures, options and derivatives that are anyway suitable only for the more evolved investors.

The objective of any investment is ultimately to make money. However, this can also be done in different ways. You may invest in stocks and make money through long term growth via capital gains. You may churn your portfolio at shorter time intervals and make profits through these transactions. You may finally buy and sell at very short span of time to make money.

Let us start by looking at what is known as Day trading. A day trader bets on daily movement of stocks, ideally something that can be bought in the morning and sold off during the day. This can have good potential of earning, especially in a volatile market. However, this does require a reasonable amount of capital and has a risk of loss too. If you want to be a day trader, you must have great discipline in squaring off your positions by the end of the day even if you are at a loss. Remember that this requires a lot of involvement and is pretty much a full time job. On the positive side people who have been successful in this have really earned greatly out of this. Whatever you earn out of a salary can seem trivial compared to what even a moderately successful day trader earns. Remember, it is not easy at all to do this well.

Short term trades where you are betting on stock movements over a duration of weeks or months is another option. Here you will need to be stock specific and take calls on how the company will do in terms of news flows, sentiments and consequently stock prices over the short term. There is great potential of making money here as long as you accept there will be some losses on individual stocks. You need to build up a portfolio and churn within that. I have some friends who do this very successfully and earn handsomely out of it, enough not to worry about doing other things in life. This has far less risk associated with it than Day trading.

Finally we come to long term holding of equities or “buy and hold” as it is often called. Here you bet on stocks for the long term and make changes to your portfolio only if the company really does badly. There is a risk here of being saddled with duds from time to time ( Kingfisher Airlines in my case ), but if your selection is careful your overall portfolio should do well over the long run. The added advantage here is that you will get dividend yield too. The rewards can be spectacular at times – I bought L & T at 60 Rs a share and that 6000 Rs investment is worth 2 lacs today, apart from 1.5 lacs that I have sold and the dividends gained.

If you are wanting regular income from the stock markets you can choose short term trading. If all your income has to be from the stock market you can look at Day trading. However, for most of us who have limited time and money, the last option is really the most pragmatic one. It will require a certain amount of money, knowledge and understanding of business and loads of patience.

The rewards that you get out of it are well worth the effort though.

Financial independence #9 – your passive income stream

In the last post we looked at an investment plan that will enable you to reach your desired state of financial independence at the chosen time. As we are going to depend on passive income for the intervening years between achievement of FI and formal retirement, it will be important to set up a passive income stream for this period.

It is important to reiterate that passive income happens out of actions or investments that you have undertaken earlier. Examples can be rent, dividends, interest, capital gains etc. Reorganizing your assets such as sale of property or trading income from the stock markets cannot be termed as passive income. There is nothing wrong with these or indeed in earning other regular forms of Active income. It is just that to be truly in a state of FI your need for Active income should be absent. So any active income you are earning can cater to further investment or any indulgences that were not planned for otherwise.

To set up a passive income stream you will need to keep two things in mind. Firstly, the income must be there with a high degree of certainty as you will depend on it. Secondly, as far as practicable you must try and reduce the tax incidence on this income. Obviously the more tax you pay, the higher passive income you will need and the longer time will be required for getting to the state of FI. With these conditions in mind you will need to start setting up a passive income stream at least 3 years before your chosen date for FI.

Your choice of passive income will very much depend on what you are comfortable with. I will therefore not attempt to give any prescription here, but suggest some options that you can consider. In an earlier post, I have already shared the passive income stream that I have set up for myself and you can take some pointers from there too.

  • You’ll be getting some dividends from your stock portfolio. Estimate this accurately by averaging the dividends earned from your portfolio over the last few years.
  • The above will be true for Equity Mutual Funds with Dividend option too, but most of you would have chosen the growth option. Redemption of MF is really a strategy to be used in Retirement so do not consider it here.
  • Rental income from any property that you may own.
  • Dividend income from Debt Mutual Funds if applicable.
  • Capital gains from FMP redemption. Say you have 30 lacs in FMP and 10 lacs mature after 3 years of holding every year. On an average you will get LTCG of at least 2.4 lacs a year which will be tax free. If you are not comfortable with FMP you can set up the same mechanism with other debt funds. I prefer FMP due to certainty of interest rate.
  • Withdrawal of monet from your PPF account.
  • Interest earned from FD, POMIS, NSC, KVP etc.

You need to set up the passive income stream so that all your planned expenditure can be met through these for the years till retirement. Success in doing this without any worries will signify true Financial Independence.