11 Feb 2018 19:27 IST

Tax deduction or exemption? The difference

Both serve the purpose of lowering tax, but are different provisions of the I-T Act

There are many options under the Income Tax Act that can help you lower your tax liability and if, utilised fully, can reduce your tax outgo by a considerable amount.

Two such options are tax ‘exemptions’ and tax ‘deductions’. The Budget too introduced a standard ‘deduction’ and cut down on some ‘exempt’ allowances for the salaried class. But these two words are often used interchangeably and are considered by many to be one and the same.

Reduction from head of income

Though both deductions and exemptions serve the same objective of lowering your taxes, in reality, tax exemption and tax deduction are different provisions of the Income Tax Act. Thus, it is extremely crucial to understand the difference.

Exemption is basically a reduction from a particular head of income and can be claimed under that particular head of income only. Income from a specific head is calculated after deducting the exemptions, and the income from different heads is added to arrive at the gross total income. Thus, exemptions are excluded from the gross total income of an individual. Depending upon the type of income, they may be completely or partially exempt from tax.

To give you an example, house rent allowance, leave travel allowance and leave encashment are some exemptions that are claimed only from income from salary.

If you receive HRA as a component of your salary, it is deductible from your gross salary for income tax computation to the lowest of the three conditions - Actual HRA received; 50 per cent of [basic salary + DA] for those living in metro cities (40 per cent for non-metros); actual rent paid less 10 per cent of salary.

In most cases, you would notice a couple of hundreds being deducted towards ‘professional tax’ each month; this typically adds up to ₹2,500 annually. This is a tax levied by states. You can actually reduce this amount from your gross income while computing taxes — this tax is an exempt component.

Reduction from gross income

Deduction, on the other hand, is a reduction from the gross total income of the taxpayer. Tax deductions were basically introduced to incentivise and encourage investors to start saving and investing for long-term financial goals. For example, Section 80C allows certain investments and expenses to be deducted from the gross total income before computing income tax incidence to an extent of ₹1.5 lakh.

If you’ve got an education loan, all the interest you pay on the loan is deductible under Section 80E. There’s no maximum limit to the amount; however, you can get this deduction only for eight years of payment, starting from when the repayment begins. Health insurance premia paid for you, your spouse or dependent children are deductible to the extent of ₹25,000. Premia paid towards a health insurance for your parents allows for an additional ₹25,000 as a deduction, and goes up to ₹50,000 if your parents are above 60 years of age.

Thus, both tax exemptions and tax deductions serve the same purpose of lowering your tax outgo but they are two different things. To make the most of these provisions, you must fully understand the difference between them.

(The writer is co-founder, Fisdom.com. The article first appeared in The Hindu BusinessLine.)