Basic Concepts of Income Tax With Simple Examples

If you get scared by the two words—income tax—you are not alone. Taxation is like mathematics in school, most people hate it because they never try to understand it. This article aims to change that by explaining everything you need to know about paying tax. Let us start with the basics. As per Oxfords Learners Dictionaries, Tax is defined as “money that you have to pay to the government so that it can pay for public services.”

What Is Income Tax?

It is a form of taxation that individuals, Body of Individuals (BOI), Association of Persons (AOP), Hindu Undivided Family (HUF), and businesses need to pay to the central government. The government levies the tax on your income during a financial year and uses the money for the country’s development. These taxes help the government pay for services and infrastructure that benefit the community, such as schools, hospitals, roads, and public safety. The tax amount depends on your income and the tax slabs. There are two types of taxes: Direct and Indirect taxes.
‘Direct Taxes’ are taxes paid directly by individuals or organizations to the government. The most common example is income tax, which you pay on the money you earn.

Indirect Taxes are taxes that are collected by an intermediary (like a retailer) from the person who ultimately pays the tax (the consumer). Examples include sales tax or Goods and Services Tax (GST), which you pay when you buy goods or services.

What Are Income Tax Sabs (Tax Brackets)?

The income tax slab is a block under which the government groups people’s income. The amount of payable tax depends on your income during a financial year. There are currently two categories of tax slabs—the old regime and the new regime.

Moreover, since Budget 2020, you may choose to pay taxes under a new regime. Although the tax rates under the new regime are lower, you can enjoy the advantage only if you do not use the tax exemptions and deductions.

There are two other tax slabs for people aged between 60 and 80 and for those over the age of 80 years.

The below table details the tax slabs for people below the age of 60 under the old regime.

Example 1: For a person with an annual salary of Rs. 10 Lakh

Old Tax Regime

1. Income up to ₹2,50,000: Nil
2. Income from ₹2,50,001 to ₹5,00,000: 5% of (₹5,00,000 – ₹2,50,000) = 5% of ₹2,50,000 = ₹12,500
3. Income from ₹5,00,001 to ₹10,00,000: 20% of (₹10,00,000 – ₹5,00,000) = 20% of ₹5,00,000 = ₹1,00,000

Total Tax = ₹12,500 + ₹1,00,000 = ₹1,12,500

Assuming the individual can claim deductions (e.g., under Section 80C, 80D) up to ₹1,50,000, the taxable income becomes ₹8,50,000:

1. Income up to ₹2,50,000: Nil
2. Income from ₹2,50,001 to ₹5,00,000: 5% of ₹2,50,000 = ₹12,500
3. Income from ₹5,00,001 to ₹8,50,000: 20% of (₹8,50,000 – ₹5,00,000) = 20% of ₹3,50,000 = ₹70,000

Total Tax = ₹12,500 + ₹70,000 = ₹82,500

New Tax Regime u/s 115BAC

1. Income up to ₹3,00,000: Nil
2. Income from ₹3,00,001 to ₹6,00,000: 5% of (₹6,00,000 – ₹3,00,000) = 5% of ₹3,00,000 = ₹15,000
3. Income from ₹6,00,001 to ₹9,00,000: 10% of (₹9,00,000 – ₹6,00,000) = 10% of ₹3,00,000 = ₹30,000
4. Income from ₹9,00,001 to ₹10,00,000: 15% of (₹10,00,000 – ₹9,00,000) = 15% of ₹1,00,000 = ₹15,000

Total Tax = ₹15,000 + ₹30,000 + ₹15,000 = ₹60,000

Comparison

• Old Tax Regime:
  • Without deductions: ₹1,12,500
  • With deductions of ₹1,50,000: ₹82,500
• New Tax Regime u/s 115BAC: ₹60,000

Conclusion

• Without Deductions: The new tax regime results in a lower tax liability (₹60,000 vs. ₹1,12,500).
• With Deductions: If the individual can claim deductions up to ₹1,50,000, the old tax regime may still be higher in tax (₹82,500 vs. ₹60,000 under the new regime).

Example 2: For a person with an annual salary of Rs. 7 Lakh

Old Tax Regime

1. Income up to ₹2,50,000: Nil
2. Income from ₹2,50,001 to ₹5,00,000: 5% of (₹5,00,000 – ₹2,50,000) = 5% of ₹2,50,000 = ₹12,500
3. Income from ₹5,00,001 to ₹7,00,000: 20% of (₹7,00,000 – ₹5,00,000) = 20% of ₹2,00,000 = ₹40,000

Total Tax = ₹12,500 + ₹40,000 = ₹52,500

Assuming the individual can claim deductions (e.g., under Section 80C, 80D) up to ₹1,50,000, the taxable income becomes ₹5,50,000:

1. Income up to ₹2,50,000: Nil
2. Income from ₹2,50,001 to ₹5,00,000: 5% of ₹2,50,000 = ₹12,500
3. Income from ₹5,00,001 to ₹5,50,000: 20% of (₹5,50,000 – ₹5,00,000) = 20% of ₹50,000 = ₹10,000

Total Tax = ₹12,500 + ₹10,000 = ₹22,500

New Tax Regime u/s 115BAC

1. Income up to ₹3,00,000: Nil
2. Income from ₹3,00,001 to ₹6,00,000: 5% of (₹6,00,000 – ₹3,00,000) = 5% of ₹3,00,000 = ₹15,000
3. Income from ₹6,00,001 to ₹7,00,000: 10% of (₹7,00,000 – ₹6,00,000) = 10% of ₹1,00,000 = ₹10,000

Total Tax = ₹15,000 + ₹10,000 = ₹25,000

Comparison

• Old Tax Regime:
  • Without deductions: ₹52,500
  • With deductions of ₹1,50,000: ₹22,500
• New Tax Regime u/s 115BAC: ₹25,000

Conclusion

• Without Deductions: The new tax regime results in a lower tax liability (₹25,000 vs. ₹52,500).
• With Deductions: If the individual can claim deductions up to ₹1,50,000, the old tax regime may result in a lower tax (₹22,500 vs. ₹25,000 under the new regime).

Before paying taxes on income, you can utilize the tax deductions and exemptions offered by the government. There are plenty of these tax benefits that can significantly lower your taxable income.

Income tax exemptions and deductions

Now, time for some good news. You already know that the government allows tax deductions and exemptions. These tax benefits lower your taxable income, which leads to reduced tax. However, these are available only if you choose to pay taxes as per the old income tax slabs in India.

Exemptions

Exemptions are available for salaried individuals. If you check the salary slip closely, it has some components like basic pay, travel allowance, House Rent Allowance (HRA), and others. Some of these incomes are exempted from taxation. For example, you receive HRA from the employer if you are currently living in a rented house. Even though it is a source of income, there is no need to pay any tax on it.

Deductions

Deductions are calculated on your total income during a financial year. It includes all your investments and salary. To begin with, salaried people get a standard deduction of ₹50,000 on their salary. Furthermore, the Income Tax Act, 1961 has various sections under which the government allows other deductions. Some examples are as follows:

• Section 80D: It allows a yearly tax deduction of up to ₹25,000 on the premium paid towards health insurance policies. If you buy the Mediclaim for your parents, you will get an additional deduction of up to ₹25,000.
• Section 80E: It allows a tax deduction on the interest paid for the repayment of an educational loan.
• Section 80G: It allows a tax deduction on the amount paid as a donation to specific charitable organizations and relief funds.
• Section 80EE: It allows a yearly tax deduction of up to ₹50,000 on the interest paid for the repayment of a home loan.
• Section 80C: It allows a yearly tax deduction of up to ₹1.5 lakhs for investments made in National Saving Certificate (NSC), Public Provident Fund (PPF), Sukanya Samriddhi Yojana (SSY), Unit-Linked Insurance Plans (ULIPs), life insurance, Employee Provident Fund (EPF), principal payment towards home loan, Equity-Linked Savings Scheme (ELSS), Senior Citizen Savings Scheme (SCSS), and much more.

Difference between Financial Year and Assessment Year

Now that the question, “what is income tax?” is answered, it is time to know when to pay it. One of the important aspects of income tax filing is that you need to pay the tax for your income during the previous year, known as the Financial Year (FY). The year after FY is known as the Assessment Year (AY). The government assesses and taxes your income during the AY. Both FY and AY are between 1st April and 31st March.

During the AY, you need to file your taxes using the Income Tax Return (ITR) form.

What Is an ITR Form?

It is a form that you need to fill to submit the taxes. Here, you are required to provide information related to your income and applicable taxes to file income tax.

Things to know while filing the ITR form

There are seven types of ITR forms for different types of taxes in India that you need to choose from depending on your source of income, amount of income, and other factors.

• ITR-1: Resident individuals with income up to ₹50 lakhs from salary, pension, one house property, and other sources.
• ITR-2: Individuals or HUFs with income over ₹50 lakhs from sources under ITR-1 + capital gains, more than one house property, and foreign income.
• ITR-3: ITR-2 + income from a business, partnership, and presumptive income over ₹50 lakhs.
• ITR-4: Resident individuals, HUFs, and partnership firms (except Limited Liability Partnership) with presumptive income from sources under ITR-1 if income is up to ₹50 lakhs.
• ITR-5: Applicable for firms, AOP, LLP, and BOI, artificial juridical person (AJP), insolvent’s estate, investment funds, business trust, and estate of deceased.
• ITR-6: Companies not claiming Section 11 deductions.
• ITR-7: Persons and companies required to submit returns under Section 139(4A), 139(4B), 139(4C), 139(4D), 139(4E), or 139(4F).

E-filing of Income Tax Returns

You can opt for income tax e-filing to complete the process online. You may visit the Income Tax Portal and register with your Permanent Account Number (PAN). Next, you must choose the ITR form applicable for you and fill up the required sections. You can then submit it and file the tax online.

Taxation for freelancers vs. salaried employees

• Salaried individuals: If you are a salaried person, the salary you get in your bank account is after tax deductions. Your employer pays the salary only after deducting the taxes as per your investment and rent declarations.
• Freelancer: If you are a freelancer, your clients deduct the Tax Deducted at Source (TDS) from your income before making the payment. They submit the TDS to the government on your behalf. You still need to submit ITR by declaring your total income, the tax you are supposed to pay, and the amount of tax already paid. If you have already paid more than the due amount, you can apply for a refund. On the other hand, if you have paid less than the tax payable, you need to pay the remaining amount.

Understanding with an example

Now that you know the basic concepts of income tax, let us look at an example to get a clearer idea about how the calculation works.

Suppose Swati makes ₹1 lakh a month from her job. So, with an annual income of ₹12 lakhs, she belongs to the 30% tax slab. According to the Income Tax Act, 1961, she must pay ₹1,12,500 + 30% of taxable income over ₹10 lakhs (₹2 lakhs in Swati’s case).

So, her total payable tax before deductions will be ₹1,12,500 + ₹60,000 (30% of ₹2 lakhs) = ₹1,72,500.

On the other hand, if Swati decides to forgo the deduction, she can pay taxes according to the new regime. In that case, she would have to pay ₹75,000 + 20% of taxable income over ₹10 lakhs (₹2 lakhs in Swati’s case).

So, she will have to pay ₹75,000 + ₹40,000 (20% of ₹2 lakhs) = ₹1,15,000.

FAQs

What is advanced tax?

It is a tax you can pay in advance if your assessment shows a tax liability of ₹10,000 and above. You must calculate the tax on your current income and pay it in four installments.

How to know if the government received the tax?

You can check Form 26AS on the Income Tax Portal and see if your deposited tax is reflecting on it. You can also check the National Securities Depository Limited (NSDL) portal to check the service of challan status.

What if you cannot see the information on Form 26AS?

If there is an error, the website will show you the reason (wrong PAN or any other). You can then rectify it.
Now that you know the income tax basics, you can easily calculate the due amount and pay it on time. It is always recommended that you thoroughly check all the applicable tax benefits to get the maximum deduction possible.

Are tax returns your own money?

Yes, tax returns which are excess tax amount will be returned to you as per Section 237 of the Income Tax Act, 1961.

What do I need to know about taxes for the first time?

If you are starting out to understand about taxes, you need to learn about:
What Is Income Tax, various income tax slabs, tax regimes to choose as per the benefit, income tax exemptions and deductions.