Income Tax: How to minimise tax liabilities while maximising investment returns?

Almost threefold growth has occurred in Indian benchmarks over the past decade. The meteoric rise of the stock market has also attracted retail investors’ participation in India’s equity markets. Income from investments attracts taxes in the form of dividend distribution tax (DDT), long-term capital gains (LTCG), and short-term capital gains (STCG), which individual investors must understand carefully. If investors do not engage in proactive tax management, these taxes have the potential to reduce their total returns.

To help retail investors minimise their tax obligations and maximise their gains, this article aims to present some easy tax management rules, mainly for retail investors.

First, retail investors should understand the pecking order of investments in order to minimise tax liability. A well-balanced portfolio includes both taxable and tax-exempt assets. Interest earned from certain investments, such as tax-saving fixed deposits, NPS, Sukanya Samriddhi Yojana, EPF, PPF, etc., are not subject to taxes.

Investors seeking lower tax liability can explore various investment options, such as the stock market, bonds, commodities, etc., once they use all tax-free deposits available under these schemes.

Second, investors must choose between dividend and growth stocks wisely. For example, growth stocks are a better bet for investors in high-tax brackets than dividend stocks because dividend income is taxed at the same rate as current income.

Investing in several PSU and FMCG stocks can result in larger tax liabilities because of their high dividend yields. Conversely, there is a 15% cap on the capital gains from the stock market.

Another important way to reduce tax liability is to invest in assets where indexation is permissible. Certain investments such as real estate and sovereign gold bonds are eligible for indexation. Indexation lowers the total tax burden by including inflation in the acquisition cost.

In addition, investors have long-term capital gains from the sale or transfer of real estate that can be invested in 54EC Capital Gain Bonds. According to Section 54EC, any capital gain from real estate invested in these bonds would be exempted from taxation.

Investors should also consider systematic withdrawals from equity or equity-linked plans, as gains up to ₹1 lakh per annum from equity or equity-linked mutual funds are exempt from LTCG tax.

Therefore, investors should book profits of up to Rs. 1 lakh out of long-term investments every year. Such a systematic withdrawal substantially reduces tax liability.

Further, investors who wish to stay invested can book profits and buy the same securities again and hold them in the long term. Such strategic withdrawals can maintain gains within the exempted limit.

In addition, investors can lower their tax burden by selling off investments that are not doing well and using proceeds to offset their gains from other investments. The Income Tax Act allows investors to write off either long- or short-term capital gains from short-term capital losses.

However, only long-term capital gains can offset short-term losses. Therefore, it is possible to lower the tax burden by booking losses in years with higher-than-usual gains and using them to offset current-year capital gains.

In addition to straightforward strategies, investors seeking returns from foreign markets ought to undertake it in countries where India has linked the Double Taxation Avoidance Agreement (DTAA), which shields investors from paying taxes multiple times on their income, once in their home country and again in their country of origin.

In addition, non-resident Indians looking to invest in the Indian market might want to look into products available in Gujarat GIFT City, as capital gains from selling units are not subject to taxes in GIFT city.

Prof. Tarun Kumar Soni, FORE School of Management