How is taxable income calculated?

Soon, it will be that time of the year where we try to save as much of our income as we legally can from the gallows of tax cuts. Let us look at what constitutes an individual’s taxable income.

Jan 24, 2020 12:01 IST India Infoline News Service

Each new year brings with it a lot of new beginnings, resolutions, and promises. What it also brings in is the need to put our financial house in order. Soon, it will be that time of the year where we try to save as much of our income as we legally can from the gallows of tax cuts. It is important to review our financial statements in order to make sure that only the required tax is being deducted from our annual income. For this, we need to understand that that there is a difference between gross annual income and taxable income. Now that we have an agenda in place, let us look at what constitutes an individual’s taxable income.
 
Step 1- Consider your various income sources
As per the income tax laws, a person can have a total of 5 sources of income i.e.: Income from salary, Income from House Property, Income from Business or Profession, Income from Capital Gains, Income from Other sources. All income of a tax-assessee has to be categorized as one of the above.
 
This can be illustrated in the following manner-
Income from Salary This includes salary paid to an employee in cash as well as the taxable perquisites made available to the employee
Income from House Property Income from house property mainly consists of rental income received by the assessee from the house that he has let out
Income from Capital Gain Income from gain or loss when you sell a capital asset
Income from Business or Profession Income/loss that arises as a result of carrying on a business or profession
Income from Other Sources Any income not classified under any other head of income such as salary, house property, business/ profession and capital gain fall under the category of income from other sources. Such income primarily includes interest income earned from savings bank account, deposits, lottery income, dividend income, etc.
 
Step 2- Calculate your gross income
While computing income under each head of income, a taxpayer is allowed certain exemptions and/or deductions, subject to the satisfaction of conditions. After computing income under each head, the aggregate of all the above heads of income result in Gross Total Income (GTI).
Gross income is the starting point from which the Income tax department (IT department) calculates an individual's tax due. Gross income includes any income not explicitly designated by the IT department as tax-exempt. Gross income essentially includes any source of income that an individual might have viz. wages, bonuses, commissions, capital gains or dividend income from investments, or income from property rentals. Some withdrawals from retirement accounts, Social Security benefits or disability income may also qualify to be included in the calculation of gross income.
  • For a self-employed individual or a business owner, gross income is the total revenue obtained from the business, minus any allowable business expenses. Gross income for business owners is referred to as net business income.
  • Let us illustrate this with an example
  • Rohan has a basic salary of Rs800,000/ annum, HRA of Rs300,000, special allowance of Rs60,000 and LTA of Rs20,000. Rohan pays a rent of Rs21,000.
  • First let us understand how his income from salary is calculated. The following components are included in your salary:
  • Basic Salary
  • Bonuses and commissions
  • Allowances (these can be taxed fully, partially or totally exempt from tax)
  • Fully taxable allowances include Dearness Allowance (DA), Overtime Allowance (OA) and city compensatory allowance (for those who move to metros like Mumbai, Delhi, Kolkata, and Chennai)
  • Partly taxable allowances include House Rent Allowance (HRA), entertainment allowance, and other special allowances
  • Fully exempt allowances include foreign allowance (for employees who are posted in other countries), allowance of high court and supreme court judges, etc.
Salary components Amount Tax exemption Taxable Income
Basic Salary 800,000 - 800,000
HRA 300,000 172,000 128,000
Special Allowance 60,000 - 60,000
LTA 20,000 12,000 8,000
Standard Deduction - 40,000 -
Gross Total Income from Salary 1,180,000 224,000 996,000
 
Now, apart from this salary income, Rohan also has income from interest income from his fixed deposit which comes at up to Rs10,000 and an interest from his savings deposit at Rs7,500. So, his gross income can be calculated as follows:
Sources Amount
Income from Salary 996,000
Income from Other Sources 17,500
Gross Total Income 1,013,500
 
Step 3- Understand deductions
The Income Tax Act allows a taxpayer to claim deductions from his income. Additionally, certain kinds of income are exempt from tax, and are therefore not considered while calculating income tax. The Act provides that if a taxpayer incurs certain specified expenditure or makes investments in certain specified instruments, the amount of expense/ investment may be allowed as a deduction from GTI to arrive at total income. This provides opportunity for taxpayers to plan taxes.
 
Some of the common deductions available to taxpayers are under Section 80C, Section 80D, Section 80CCC, Section 80CCD, Section 80CCE, Section 80E, Section 80G of the Act amongst others. We all are aware of the popular deductions like deductions under 80C (up to Rs150,000), but there are many more deductions that can be claimed by the assessee. Make sure you claim all the relevant deductions from your GTI which are given under sections 80C to 80U.
 
Some of the investments/expenditures which can be claimed as deductions include, Investment in NSC, PPF, ULIPs, ELSS, NPS, VPF, Tution fee, Mediclaim policy, Life insurance policy, donations given to certain approved institutions, royalty income received by the author of books, etc.
 
Step 4-Computing Taxable income
Once you subtract the deductions and exemptions from the gross total income, you will arrive at the taxable income.  We can illustrate this is the following manner- Rohan has invested Rs50,000 in Public Provident Fund (PPF) and Rs20,000 in tax saving mutual funds. Additionally, over the last year, he paid a premium of Rs80,000 for a life insurance policy, and paid Rs10,000 for medical insurance.
Deductions  Amount
80C  1,50,000 (PPF+ELSS funds+ LIC policy)
80D  10,000 (medical insurance)
Total 160,000
 
Hence, Rohan’s taxable income = Gross total income - total deduction s= Rs1,013,500-160,000=Rs853,500.

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