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Difference Between Tax Deduction and Tax Exemption in India

Difference Between Tax Deduction and Tax Exemption in India

When dealing with taxation, we often encounter several complex terms. Some of the most common are “deductions” and “exemptions.” Deductions reduce the amount of income that can be taxed, whereas exemptions exclude certain types of income from taxation altogether. Understanding the difference between exemptions and deductions is crucial to managing your taxes efficiently. 

Tax deductions refer to specific investments or expenses that may be deducted from taxable income. Tax exemptions, on the other hand, refer to parts of income that are exempt from taxation to begin with. In this article, we look deeper into what the two terms mean and the exemption and deduction difference. 

Difference Between Deduction and Exemption in Income Tax

It is important to know what differentiates tax exemption vs deduction. The table below highlights the key differences between exemption and deduction in income tax.

AspectTax DeductionTax Exemption
ScopeTax deductions can be applied to varied expenses and investmentsExemptions are limited only to specific categories of income
Method of ApplicationThey are deducted from one’s total income before tax calculationThey are not included in one’s taxable income at all
Impact on IncomeDeductions lower the portion of your income that is subject to taxExemptions remove certain income types from taxation
ObjectiveTheir objective is to improve one’s savings, investments, and eligible expensesTheir objective is to provide relief for certain income categories
RestrictionsThey are subjected to pre-determined caps based on the deductionThey have no tax liability, therefore no limits
Flexibility They are more diverse and flexible They are more uniform and standardised 
AmountThe amount significantly varies based on expensesExemptions are generally fixed amounts

What are Tax Deductions?

To understand the differences between deductions vs. exemptions, it is first essential to understand each term. Tax deductions refer to particular expenses and investments deducted from an individual’s taxable income. This lowers their taxable amount, encouraging savings, retirement planning, and other healthy financial practices. For example, Mr. Mehta’s income is Rs. 10 lakhs. He chooses to invest 1 lakh into a public provident fund. According to section 80C of the Income Tax Act, Rs. 1 lakh is then deducted from Mr. Mehta’s taxable income. Therefore, his taxable income is now only Rs. 9 lakhs. 

Here are some of the tax deductions available under various sections of the Income Tax Act, of 1961. Note that the list is not an exhaustive one.

  1. Schemes under Section 80 C: Under Section 80C, when individuals invest in a Public Provident Fund (PPF), Equity-Linked Savings Scheme (ELSS), Home Loan Principal Amount Repayments, National Savings Certificate (NSC), Employee Provident Fund (EPF), Pension plans, or Property Stamp Duty and Registration Fees, the amount can be deducted from their taxable income. The limit is up to Rs. 1.5 lakh per annum. 
  1. Section 80D: Premiums ranging from Rs. 25000 to Rs. 1 lakh paid towards health insurance for individuals and families are tax-deductible. The amount also depends on the insurer’s age. Other deductions are available for the treatment of dependents’ disabilities and for specified diseases.
  1. Section 80 E: Interest paid on education and homes for first-time home buyers can also be deducted from taxable income. This tax deduction encourages higher education for students whose parents cannot afford the expensive fees. Similarly, the tax deduction on interest payments on a housing loan is provided to encourage investment in domestic real estate.
  1. Section 80 G: This section enables one to claim tax deductions on contributions to social causes and political parties. The deduction allows the government to support these organisations and social initiatives. 
  1. Section 80 TTA: Section 80TTA provides individuals with a deduction of up to Rs 10,000 on any income earned through interest on savings made in a financial institution, co-operative society or post office. 

Examples of Deductions

Some examples of tax deductions include: 

  • Donations: Charitable donations made to registered charities can be deducted from an individual’s taxable income. 
  • Educational expenses: In some cases, expenses like tuition fees could be deducted from education-related costs. 
  • Medical expenses: Under some circumstances, major dental or medical expenses could also become deductible. 
  • Mortgage interest: If an individual has a mortgage on their home, the interest may be deductible. 

What are Tax Exemptions?

In some cases, a particular portion of an individual’s income is considered to be tax-free right from its source. These portions are referred to as “tax exemptions.” Tax-exempt means that you do not need to spend or invest this portion of your income anywhere to be able to claim the exemption. 

Examples of Exemptions

Here are some examples of the same:

  1. Long-Term Capital Gains: LTCG on Equity mutual funds is typically exempt from taxation. However, it is important to note that there is a limit on this exemption. Up to Rs. 1.25 lakhs, LTCGs may be exempt. However, beyond this limit,  a tax rate of 12.5% will be implemented. 
  1. Housing Rent Allowance: HRA is part of an employee’s salary and is tax-exempt if the employee lives in a rental house. However, it cannot exceed at least one of the following: The rent paid, minus 10% of the taxpayer’s salary; any actual HRA received from the employer; or a portion of their salary (50%  for employees in metro cities, and 40% for those not in metro cities). 
  1. Leave Travel Allowance: Some employers may also pay employees a Leave Travel Allowance, which is often used for travelling during time off. Taxpayers can claim exemption on this amount. However, it is important to note that this exemption may only be availed of once in 4 years. 
  1. Agricultural Income: All agricultural income in India is exempt from taxation. This is because agriculture is the only source of income for many in rural India. The country is also entirely dependent on farming for food security. If it was not tax-exempt, food would become too expensive.
  1. Lowest Income Tax Slab: An income of Rs. 5 lakhs and below is completely exempt from income tax. This means that if one has an income of Rs. 7 lakhs, Rs. 2 lakhs is taxable income. 

New Tax Regime

A new tax regime has been introduced in Budget 2023. As per this regime, the following changes have been made:

  • Various tax exemptions and deductions such as HRA, LTA, Section 80C, etc. have been done away with. However, the income exempted from income tax has been increased to Rs. 7 lakhs.
  • While one has the option to continue to file taxes under the old tax regime, unless the taxpayer specifies otherwise, the new regime will be the default applicable regime. 
  • Taxpayers must choose one of the tax regimes after taking into account the difference between exemption and deduction in income tax as available in the old regime against those available in the new regime for their income. 
  • It is advisable to choose one regime over the other only after calculating the tax payable under each of these regimes. 

Conclusion

While the terms exemption and deduction may appear similar (as both reduce a person’s total tax payable) they are entirely different concepts. Understanding the difference between exemptions and deductions can help individuals manage their finances more efficiently. Planning ahead for these can not only optimise your tax savings but also help your investment strategy and long-term wealth creation goals. To help you reach your financial goals, consider Tata Capital. Tata Capital offers various savings options, such as ELSS mutual funds, which provide the dual benefit of potential returns and tax savings.

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FAQs

Can I claim both deductions and exemptions in the same tax year?

Yes, you can claim both. Deductions and exemptions work together to help reduce your taxable income and overall tax liability within the same financial year.

Is it better to have a deduction or an exemption?

The choice depends on your situation. Both reduce taxable income differently. Deductions often depend on expenses, while exemptions may relate to your family or income structure.

Can exemptions and deductions be carried forward to the next financial year?

Carrying forward depends on the specific deduction or exemption and applicable tax rules. Some may be carried forward, while others cannot.

What happens if I incorrectly claim a deduction or an exemption?

If an individual wrongly files for an exemption or deduction, they may be subjected to interest charges or penalties. To ensure you are accurately claiming tax deductions and exemptions, it is important to consult a professional or utilise reliable tax software platforms. 

How do changes in tax laws affect deductions and exemptions?

Deductions and exemptions can be significantly affected by changes in tax laws. New laws may alter the existing deduction, and exemption amounts or introduce new ones. Staying informed about taxation regulations can help you plan your finances and maximise your savings. 

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