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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 exemption and deduction 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 primary exemption and deduction differences.

Deduction vs exemption: Meaning & key differences

It is important to know what differentiates a tax exemption from a deduction. The table below highlights the key differences between deduction and exemption 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
FlexibilityThey are more diverse and flexibleThey are more uniform and standardized
AmountThe amount significantly varies based on expensesExemptions are generally fixed amounts

Tax deduction meaning & top examples (India)

To understand the difference between exemption and deduction, 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 Rs. 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 80C: 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.
  2. Section 80D: Premiums ranging from Rs. 25,000 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.
  3. Section 80E: 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.
  4. Section 80G: This section enables one to claim tax deductions on contributions to social causes and political parties. The deduction allows the government to support these organizations and social initiatives.
  5. Section 80TTA: 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.

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.

Tax exemption meaning & top examples (India)

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 exemption’s meaning in income tax is that you do not need to spend or invest this portion of your income anywhere to be able to claim the exemption.

To understand what an exemption in income tax is, let’s look at some examples:

  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 lakh, LTCGs may be exempt. However, beyond this limit, a tax rate of 12.5% will be implemented.
  2. 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).
  3. 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 an exemption on this amount. However, it is important to note that this exemption may only be availed of once every 4 years.
  4. 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 were not tax-exempt, food would become too expensive.
  5. 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.

How to decide: When to use deduction or exemption for tax savings?

If you are confused about when it’s right to use tax deductions or exemptions, you must know that the decision is dependent on your income, expenses, and chosen tax regime. Deductions reduce your taxable income, while exemptions exclude certain income from tax. Read on to learn how you can make an informed decision:

  • Learn about the different tax regimes: Under the old tax regime, you can claim many tax deductions and exemptions. But under the new tax regime, the tax rates are lower, and the benefits are fewer.
  • Check your expenses: If you have invested in PPF, ELSS, insurance, or pay home loan interest, deductions may give better savings.
  • Consider your salary structure: Under the old tax regime, allowances like HRA or LTA work as exemptions.
  • Compare both options: Calculate taxes under both old and new regimes before filing.

You must choose the option that gives lower tax and suits your financial habits.

Section 10, 80C, and HRA: Key tax exemptions and deductions

The following tax exemptions and deductions can help reduce taxable income and save on taxes when used properly.

  • Section 10: It covers tax-free income like HRA, LTA, gratuity, and certain allowances, mainly for salaried employees under the old tax regime. HRA refers to house rent allowance. It provides an exemption on rent paid, based on salary, rent amount, and city of residence.
  • Section 80C: It allows you to claim deductions of up to Rs. 1.5 lakh for investments like PPF, ELSS, life insurance, EPF, and tuition fees.

New tax regime

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

  • Various tax deductions and exemptions, 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 deduction and exemption 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 tax deductions and exemptions may appear similar (as both reduce a person’s total tax payable), they are entirely different concepts. Understanding the exemption and deduction differences can help individuals manage their finances more efficiently. Planning ahead for these can not only optimize 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. 

What is the main difference between a tax exemption and a deduction in India?

A tax exemption removes certain income from being taxed, while a tax deduction reduces your total taxable income after it is calculated. Both help lower taxes, but they work differently.

Are tax deductions and exemptions both allowed under the new regime?

No, the new tax regime allows very limited deductions and almost no exemptions. Most benefits, such as 80C, HRA, and LTA, are available only under the old tax regime.

What are some popular exemptions and deductions Indian taxpayers can claim?

Some popular exemptions include HRA and LTA. Similarly, some common deductions include Section 80C investments, Section 80D health insurance, and home loan interest under Section 24.

What is an HRA - a tax exemption or deduction?

HRA is a tax exemption. It helps to reduce taxable salary if you pay rent. However, you must meet the required conditions under the old tax regime to claim the exemption.

How do I choose between using deduction or exemption for tax savings?

To choose between deduction and exemption, you must first understand deduction and exemption meaning in income tax. Then, compare the tax under both regimes based on your income and expenses. If you have high investments and allowances, the old regime may help save more taxes.

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