Investing in stocks has long been a popular way to build wealth and create long-term financial stability. However, many investors overlook the fact that investing in stocks can also have significant tax-saving benefits. By investing in stocks, investors can claim deductions under various sections of the Income Tax Act, such as Section 80C, Section 80D, Section 80TTA, and Section 80G. Additionally, holding stocks for more than one year can also provide long-term capital gains tax benefits which is one of the most prominent ways to save income tax.
In this article, we will discuss in detail how investing in stocks can help individuals save income tax and what strategies they can use to maximise these benefits. By understanding how to save income tax through stock investments, investors can not only build wealth but also create a strong financial foundation for their future.
What is Income Tax?
Income tax is a tax that is levied on the income earned by individuals, businesses, or other entities. It is a direct tax that is levied by the government to generate revenue for various public welfare programs, infrastructure development, defence, and other government functions.
The Income Tax Act, 1961 governs the provisions of income tax in India. Income tax is levied on various types of income such as salary, business income, capital gains, interest income, rental income, and other sources of income. The tax rates and exemptions vary depending on the source and amount of income earned by the taxpayer.
There are several provisions and deductions available under the Income Tax Act, which allow taxpayers to save income tax. These include deductions for investments made in specified instruments, such as PPF, ELSS, NSC, and ULIP, and deductions for health insurance premiums, donations to specified charitable institutions, and interest earned on savings bank accounts.
Tax Benefits of Equity Investments
There are many benefits to investing in equity. Investments in equity help tax-payers reduce their tax liability and save income tax. The components of the equity market include shares, futures, and derivatives. The tax advantages of stock investment are mentioned below:
Stocks are tax-free investments
The concept of shares being tax-free investments may seem unreal. However, the reason behind this is simple. For instance, you may own shares in a company called XYZ, which has allocated a portion of its profits for distribution among its shareholders or equity holders, known as dividends. Many companies pay out dividends to their shareholders regularly or periodically, providing them with a consistent source of income.
The good news is that any dividends you receive help you save income tax as they are tax-free. All you need to do is report the information in Form 16, under the section designated for the necessary details. This aspect makes equity share investment stand out as it offers tax-free benefits, unlike other taxable investment options.
Option to set off capital gains
Equity investment offers significant tax advantages, including the ability to offset capital gains. If you sell your shares within six months, you may generate short-term capital gains. Nonetheless, if you have incurred losses in other types of investments, you may offset the capital gains from the sale of equities against the short-term capital loss from a different investment. This strategy can help you save income tax.
For example, let’s say you sell shares in a company for a profit of $5,000, but you also have a capital loss of $3,000 from another investment. You can use the $3,000 capital loss to offset the $5,000 capital gain, resulting in a net capital gain of only $2,000. This means you will only have to pay taxes on the $2,000 gain, rather than on the full $5,000 gain, thereby reducing your tax liability and helping you save income tax.
Option to carry forward losses
It is possible to carry forward any capital gains obtained from selling shares into the next fiscal year. In the event of selling shares at a loss due to distress, the resulting capital losses can be used to offset capital gains earned from selling profitable shares. This offset can be done for up to 8 consecutive years, but it is essential to ensure that both the capital gains and losses belong to the same investment class.
This means that if one has made a profit from selling shares, those profits can be used to offset losses incurred from selling other shares. One can save income tax by using both offsetting and carry-forward options simultaneously.
For example, let’s say that John made a profit of $10,000 by selling shares in 2022. He also had a loss of $5,000 from selling other shares in the same year. In this scenario, John can use the loss of $5,000 to offset the gain of $10,000, which means he will only have to pay taxes on the net gain of $5,000.
Now, if John does not have any other gains or losses for the rest of the year, he will owe taxes on the $5,000 gain. However, if he chooses to carry forward the capital loss of $5,000, he can offset this loss against any future capital gains in the next eight consecutive years.
Suppose John makes a capital gain of $10,000 in 2023. In this case, he can use the carried forward loss of $5,000 to offset the gain of $10,000, which means he will only have to pay taxes on the net gain of $5,000. By doing this, John has effectively deferred the taxes on his 2022 gains to 2023 and effectively took a step to save income tax.
Equity-linked saving scheme
An Equity Linked Saving Scheme (ELSS) is a type of mutual fund investment scheme that invests primarily in equity shares of companies. ELSS funds are designed to help investors save income taxes while providing the potential for high returns through investments in equity markets.
One of the main advantages of ELSS funds is that they offer tax benefits under Section 80C of the Income Tax Act, 1961. An investor can claim a deduction of up to Rs.1.5 lakh in a financial year for investments made in ELSS funds. Additionally, ELSS funds have a lock-in period of 3 years, which means that investors cannot withdraw their money before this period ends.
Here are a few examples of popular ELSS funds in India:
- Aditya Birla Sun Life Tax Relief 96 Fund
- Axis Long-Term Equity Fund
- DSP Tax Saver Fund
- HDFC TaxSaver Fund
- ICICI Prudential Long Term Equity Fund (Tax Saving)
- Reliance Tax Saver (ELSS) Fund
- SBI Magnum Tax Gain Fund
- Tata India Tax Savings Fund
It is important to note that while ELSS funds can offer potentially high returns, they also come with a higher level of risk due to their investments in equity markets. Investors should consider their risk appetite, investment goals, and investment horizon before investing in ELSS funds. It is always advisable to consult with a financial advisor before making any investment decisions.
Exemption Under Section 54F of the Income Tax Act
Section 54F of the Income Tax Act allows for an exemption on long-term capital gains resulting from the sale of any capital asset, except for residential property, if the proceeds are utilised for purchasing a residential house. This exemption applies to various forms of capital assets, including equities, jewellery, bonds, and others. Although the capital gains are subject to taxation based on the relevant regulations, utilising the proceeds to purchase a residential property entitles the seller to claim this exemption.
Condition to claim the exemption
- Section 54F provides an exemption that is exclusively available to individuals and Hindu undivided families (HUFs).
- It is essential to note that only one residential house, aside from the one you intend to purchase now, should be in your possession at the time of selling the original asset.
- To claim the exemption, the purchase of the new house must occur either within one year before or two years after the date on which the capital asset is sold.
- It is mandated that for the sale of a capital asset like a house, the construction of a new property must be completed within three years.
- If you are unable to use the sale proceeds for the intended purpose before the due date for filing the income tax return of the financial year in which the sale occurred, it is advisable to transfer the funds to a “capital gains account” with a bank.
- However, it is important to note that this exemption can be reversed in certain circumstances. For instance, if you sell the new property within three years of its purchase or construction, purchase another residential house within two years of the sale of the original asset, or construct a residential house other than the new one within three years of the sale of the original asset, the capital gains from the sale will be taxed as long-term capital gains.
Portion of capital gains exempted
To illustrate this concept, suppose an investor has sold assets with a total value of approximately Rs 60 lakh, and has realised a capital gain of Rs 10 lakh from this sale. If the investor subsequently chooses to reinvest this amount in the purchase or construction of a residential property, the exempted capital gains amount can be determined as follows:
Case 1: Entire amount is re-invested
If an individual chooses to reinvest the entire amount from the sale of assets into purchasing or constructing a residential property, the entire capital gains amount, which in this case is Rs 10 lakh, can be exempted, according to Value Research.
Case 2: Part of the sale proceeds is exempted
In situations where only a portion of the sale proceeds is reinvested, the capital gains exemption under Section 54F is calculated based on the proportion of the amount reinvested, as per ClearTax.
Last but not the least
Investing in stocks can be an effective means to save income tax while also potentially earning significant returns on your investment. By conducting thorough research and analysis of the performance and risk of individual stocks, you can make informed decisions that align with your financial goals and tax-saving objectives.
It is important to note that investing in stocks does involve risk, but this can be mitigated by diversifying your portfolio and conducting ongoing monitoring and evaluation of your investments. Additionally, taking advantage of tax-saving instruments such as the long-term capital gains exemption and Section 80C deductions can further optimise your tax savings.
Overall, the benefits of investing in stocks for tax-saving purposes are significant, but it requires discipline, patience, and a willingness to learn and adapt. By leveraging the expertise of financial advisors, keeping a long-term perspective, and continuously refining your investment strategy, you can maximise your tax savings and achieve your financial goals.
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Frequently Asked Questions(FAQs)
- Can I save income tax by investing in foreign stocks?
Ans: Yes, investing in foreign stocks through mutual funds or other vehicles can provide exposure to international markets and potentially offer tax-saving benefits.
- Are there any tax-saving benefits of investing in mutual funds?
Ans: Yes, investing in equity-linked saving schemes (ELSS) can provide tax deductions under Section 80C, as well as long-term capital gains exemption if held for more than one year. It thus help one to save income tax.
- What are the risks associated with investing in stocks for tax-saving purposes?
Ans: Investing in stocks always carries risk, including market volatility, economic downturns, and company-specific factors. It’s important to conduct thorough research and analysis before investing in any particular stock.