In one of the previous posts, I had discussed about how clubbing provisions could be attracted if you invested in the name of family members.
In this post, let’s look at some of the ways where you could invest in the name of family members and still avoid/reduce the impact of clubbing provisions.
Must Read: PFP Primer: Clubbing of Income
1. Invest in instruments that provide tax-free returns
You can gift money to your spouse and invest the amount in a tax-free instrument. For instance, he/she can invest in PPF, equity mutual funds tax-free bonds etc.
PPF falls under EEE tax regime. Interest on tax-free bonds is tax-free bonds is exempt from tax. There is no tax either on long term capital gains on stocks or equity mutual funds. Short term capital gains on equity funds are taxable though.
Even though such income will be clubbed with your income, there will be no additional tax liability for you since such income is exempt from tax.
You might ask, what’s the point? This income would have been tax-free in your hands too. What’s the point in investing in the name of spouse (or minor children or daughter-in-law)?
Next point will make it clear.
2. Income from income is not clubbed
You invest Rs 10 lacs in a fixed deposit (8% p.a.) in the name of your wife. She gets Rs 80,000 as annual interest. This income will be clubbed with your income and taxed accordingly.
Your wife uses this Rs 80,000 and invests in a new fixed deposit (8%). She will earn interest of Rs 6,400 on this FD. This Rs 6,400 will not be clubbed with your income. This is her income. Hence, tax liability on this Rs 6,400 can be much lower.
She could have also used this Rs 80,000 to invest in any instrument. Any return/income from that instrument will be her income (and will not be clubbed).
Hence, income from re-invested earnings is not clubbed. As I understand, this rule is not applicable in case of minor children.
Consider two scenarios. You invest in tax-free bonds. You will earn tax-free interest. If you reinvest this interest income in a fixed deposit, the interest income will be taxed at your marginal income tax rate.
In the second scenario, you invest in tax-free bonds in the name of your spouse. Interest is tax-free and does not create any tax liability when it is clubbed with your income. However, if your spouse re-invests this interest income in a fixed deposit, the interest on new FD will not be clubbed with your income. Such interest on FD will be taxed at your spouse’s marginal income tax rate.
So, if your spouse does not have any source of income (or falls in lower income tax bracket), there is tax to be saved by investing smartly in her name.
3. You can invest more than the cap in PPF
Even though you may think of PPF as the best investment product in the world, you cannot invest more than Rs 1.5 lacs combined in your account (or those accounts where you are the guardian). Even if you manage to deposit more than Rs 1.5 lacs, the excess amount will not earn any interest as per PPF Act.
Now, consider this scenario. You gift money to spouse, major children or parents (or any other relative under Section 56 of the Income Tax Act). Such transfer is not taxable in the hands of the recipient. Your spouse, major children and parents can further invest Rs 1.5 lacs each per year in their PPF accounts.
On a different note, you get tax benefit under Section 80C for investing in PPF account of your spouse and children. The tax benefit is limited Rs 1.5 lacs per financial year though.
In a family of six (self, spouse, parents and two major children), you can deposit Rs 9 lacs (Rs 1.5 lacs X 6) per financial year in PPF.
Please understand when you gift money, you are essentially transferring the ownership of asset too. This can be a problem in case of family dispute.
Must Read: All you need to know about PPF
I am not saying that you must maximize your investments in PPF. That will depend on your financial goals. All I am saying is that you can invest more in PPF (if you want) through your family members.
4. Gift to major children or parents
As mentioned in the previous point, gifts to major children or parents are exempt from tax. Additionally, clubbing provisions under Section 64 do not apply for income from assets transferred to major children and parents.
Clubbing provision under Section 64 apply only to minor children, spouse and daughter-in-law (son’s wife).
If your parents or major children are in lower tax brackets, then you can invest in their name.
For instance, you are in 30% income tax bracket. However, your mother does not have any source of income. You could gift her Rs 30 lacs. At 8% per annum, she will earn interest of Rs 2.4 lacs on a fixed deposit.
Your mother’s income will not be clubbed with yours.
At annual income of Rs 2.4 lacs, she will not have to pay any tax. There will be TDS deduction unless she files Form 15H. However, excess TDS always be claimed back by filing income tax return.
5. Gift at the time of marriage (before marriage)
You can gift your fiancée (would-be-spouse) or your son’s fiancée (would-be-spouse) at the time of marriage.
Under Section 56, gifts received at the time of marriage are exempt from income tax. Hence, there shall be no income tax liability in the hands of the recipient.
Any income from investment made out of such transfer will also not be clubbed with your income.
This is because, for clubbing provisions to apply, the relation of spouse, daughter-in-law and minor children should exist both at the time of transfer of asset (gift) and at the time of accrual of income.
6. Invest in a way that the your children turn major at maturity of investment
Consider investment in debt mutual funds. Tax liability arises only at the time of redemption of units. When you invested, you daughter was a minor.
At the time of redemption, she has turned major. No clubbing is applicable in such cases.
This is because your daughter is not minor at the time of redemption (the relation of parent and minor child does not exist at the time of income generation).
7. Loan money to spouse/daughter-in-law
You loan money to your spouse. Your spouse uses the proceeds to start a business or purchase an asset and use income from the asset/business to repay the loan.
Clubbing provision (for income from such business/asset) will not apply in such a case.
However, have a loan agreement in place. Loan should not be without interest or else it will be considered indirect transfer by taxmen.
8. Pay rent to your parents
If you are staying in your parents’ house, you can pay rent to them and avail HRA (house rent allowance) tax benefit.
This can be particularly useful when your parents fall in lower income tax bracket.
Suppose you stay in Mumbai. Your basic salary is Rs 50,000 per month and your HRA is Rs 30,000 per month. If you pay Rs 25,000 per month rent to your parents, your taxable income will go down by Rs 20,000 per month (minimum of 50% of Basic, Rent – 10% of Basic, HRA) or Rs 2.4 lacs per annum. For someone in the highest tax bracket, this is a cool tax saving of Rs 74,160.
Your father or mother will earn Rs 3 lacs per annum through rent. For senior citizens, the minimum tax exemption limit is Rs 3 lacs. Even otherwise, you can expect significant reduction in tax outgo at family level.
If the house is co-owned by your parents, you can split the rent for greater tax benefits.
9. Transfer Assets to Trust or Hindu Undivided Family
Another way is to transfer assets to a Trust or a Hindu Undivided Family. As these are separate entities for tax purposes, these will get fresh tax exemptions limits. At the moment, my understanding of trusts and HUFs is limited. I will talk about these in a separate post later.
You can use the aforementioned ways to reduce tax liability on your investment income. However, do remember, you are also transferring ownership of your assets to other family members. This can create problems in case of family dispute.
This is not a holistic list. If there are other ways you can use to save income tax, do leave your inputs in the comments section.
Disclaimer: I am not a tax expert. You are advised to consult a tax expert before you make such investment decisions.
Image Credit: Alan Cleaver, 2008. The original image and information about usage rights can be downloaded from Flickr.