Heads of Income: Income from Salaries

11/05/2020 3 By indiafreenotes

Income from Salaries represents one of the primary heads of income under the Indian Income Tax Act, 1961. It encompasses earnings received by an individual in consideration for services rendered to an employer, whether in the form of wages, salaries, bonuses, commissions, allowances, or perquisites. Understanding the tax treatment of income from salaries is essential for both employers and employees to ensure compliance with tax laws and optimize tax planning strategies.

SECTION I: Understanding Your Payslip

  1. Basic Salary

This is a fixed component in your paycheck and forms the basis of other portions of your salary, hence the name. For instance, HRA is defined as a percentage (as per the company’s discretion) of this basic salary. Your PF is deducted at 12% of your basic salary. It is usually a large portion of your total salary.

  1. House Rent Allowance

Salaried individuals, who live in a rented house/apartment, can claim house rent allowance or HRA to lower tax outgo. This can be partially or completely exempt from taxes. The income tax laws have prescribed a method for computing the HRA that can be claimed as an exemption.

Also do note that, if you receive HRA and don’t live on rent your HRA shall be fully taxable.

  1. Leave Travel Allowance

Salaried employees can avail exemption for a trip within India under LTA. The exemption is only for the shortest distance on a trip. This allowance can only be claimed for a trip taken with your spouse, children, and parents, but not with other relatives. This particular exemption is up to the actual expenses, therefore unless you actually take the trip and incur these expenses, you cannot claim it. Submit the bills to your employer to claim this exemption.

  1. Bonus

The bonus is usually paid once or twice a year. Bonus, performance incentive, whatever may be its name, is 100% taxable. Performance bonus is usually linked to your appraisal ratings or your performance during a period and is based on the company policy.

  1. Employee Contribution to Provident Fund (PF)

Provident Fund or PF is a social security initiative by the Government of India. Both employer and employee contribute a 12% equivalent of the employee’s basic salary every month toward employee’s pension and provident fund. An interest of about 8.55% from FY 2017-18 (earlier it was 8.65%) gets accrued on it. This is a retirement benefit that companies with over 20 employees must provide as per the EPF Act, 1952.

  1. Standard Deduction

Standard Deduction has been reintroduced in the 2018 budget. This deduction has replaced the conveyance allowance and medical allowance. The employee can now claim a flat Rs. 50,000 (Prior to Budget 2019, it was Rs. 40,000) deduction from the total income, thereby reducing the tax outgo.

  1. Professional Tax

Professional tax or tax on employment is a tax levied by a state, just like income tax which is levied by the central government. The maximum amount of professional tax that can be levied by a state is Rs 2,500. It is usually deducted by the employer and deposited with the state government. In your income tax return, professional tax is allowed as a deduction from your salary income.

Broadly your CTC will are:

  1. Salary received each month.
  2. Retirement benefits such as PF and gratuity.
  3. Non-monetary benefits such as an office cab service, medical insurance paid for by the company, or free meals at the office, a phone provided to you and bills reimbursed by your company.

Your take-home salary will are:

  1. Gross salary received each month.
  2. Minus allowable exemptions such as HRA, LTA, etc.
  3. Minus income taxes payable (calculated after considering Section 80 deductions).

SECTION III: Retirement Benefits

  1. Exemption of Leave Encashment

Check with your employer about their leave encashment policy. Some employers allow you to carry forward some amount of leave days and allow you to encash them while others prefer that you finish using them in the same year itself. The amount received as compensation for leave days accumulated is referred to as leave encashment and it is taxable as salary.

Exemption of leave encashment from tax:

It is fully exempt for Central and State government employees. For non-government employees, the least of the following three is exempt.

  1. 10 months average salary preceding retirement or resignation (where average salary includes basic and DA and excludes perquisites and allowances)
  2. Leave encashment actually received. (this is further subject to a limit of Rs 3,00,000 for retirements after 02.04.1998)
  3. Amount equal to salary for the leave earned (where leave earned should not exceed 30 days for every year of service)

The amount chargeable to tax shall be the total leave encashment received minus exemption calculated as above. This is added to your income from salary.

Relief Under Section 89(1)

You are allowed tax relief under Section 89(1), when you have received a portion of your salary in arrears or in advance, or have received a family pension in arrears.

Calculate the Tax Relief Yourself

  1. Calculate the tax payable on the total income, including additional salary in the year it is received.
  2. Calculate the tax payable on the total income, excluding additional salary in the year it is received
  3. Calculate the difference between Step 1 and Step 2
  4. Calculate the tax payable on the total income of the year to which the arrears relate, excluding arrears
  5. Calculate the tax payable on the total income of the year to which the arrears relate, including arrears
  6. Calculate the difference between Step 4 and Step 5
  7. The excess amount at Step 3 over Step 6 is the tax relief that shall be allowed.

Note that if the amount at Step 6 is more than the amount at Step 3, no relief shall be allowed.

  1. Exemption on Receipts at the Time of Voluntary Retirement

Any compensation received on voluntary retirement or separation is exempt from tax as per the Section 10(10C). However, the following conditions must be fulfilled

  1. Compensation received is towards voluntary retirement or separation
  2. Maximum compensation received does not exceed Rs 5,00,000.
  3. The recipient is an employee of an authority established under the Central or State Act, local authority, university, IIT, state government or central government, notified institute of management, or notified institute of importance throughout India or any state, PSU, company or a cooperative society.
  4. The receipts are in compliance with Rule 2BA.

No exemption can be claimed under this section for the same AY or any other if relief under Section 89 has been taken by an employee for compensation of voluntary retirement or separation or termination of services. 
Note: Exemption can only be claimed in the assessment year the compensation is received.

  1. Pension

Pension is taxable under the head salaries in the income tax return. Pension is paid out periodically on a monthly basis usually. You may also choose to take pension as a lump sum (also called commuted pension) instead of a periodical payment. At the time of retirement, you may choose to receive a certain percentage of your pension in advance.

Commuted and Uncommuted Pension Commuted pension or lump sum received may be exempt in certain cases. For a government employee, commuted pension is fully exempt. Uncommuted pension or any periodical payment of pension is fully taxable as salary.

  1. Gratuity

Gratuity is a retirement benefit that employers provide for their employees. The employee is entitled to receive gratuity when he completes five years of service at that company. It is, however, only paid on retirement or resignation. Gratuity received on retirement or death by a central, state or local government employee is fully exempt from tax for the employee or his family. The tax treatment of your gratuity is different, depending on whether your employer is covered by the Payment of Gratuity Act. Check with your company about its status, and then proceed to calculate.

If your employer is covered by the Payment of Gratuity Act, then the least of the following three is tax-exempt.

  1. 15 days salary based on the salary last drawn for every completed year of service or part thereof in excess of 6 months.

For simplicity sake, this is calculated as last drawn salary x number of years in employment x 15/26 (where last drawn salary is Basic salary and DA and number of years in service is rounded off to the nearest full year)

  1. Rs 20,00,000
  2. Gratuity actually received

If your employer is not covered under the Payment of Gratuity Act, the least of the following three is tax-exempt.

  1. Half month’s salary for each completed year of service. While calculating completed years, any fraction of a year shall be ignored.

SECTION IV: Basics of Income Tax

  1. Income Chargeable to Tax

Your income is not equal to your salary. You could earn income from several other sources other than your salary income. Your total income, according to the Income Tax Department, could be from house property, profit or loss from selling stocks or from interest on a savings account or on fixed deposits. All these numbers get added up to become your gross income.

Income from Salary All the money you receive while rendering your job as a result of an employment contract
Income from house property Income from house property you own; property can be self-occupied or rented out.
Income from other sources Income accrued from fixed deposits and savings account come under this head.
Income from capital gains Income earned from the sale of a capital asset (mutual funds or house property).
Income from business and profession Income/loss arising as a result of carrying on a business or profession. Freelancers income come under this head.
  1. Tax Rates

Add up all your income from the heads listed above. This is your gross total income. From your gross total income, deductions under Section 80 are allowed to be claimed. The resulting number is the income on which you have to pay tax.

  1. TDS on Salary

TDS is tax deducted at source. Your employer deducts a portion of your salary every month and pays it to the Income Tax Department on your behalf. Based on your total salary for the whole year and your investments in tax-saving products, your employer determines how much TDS has to be deducted from your salary each month.

For a salaried employee, TDS forms a major portion of an employee’s income tax payment. Your employer will provide you with a TDS certificate called Form 16 typically around June or July showing you how much tax was deducted each month.
Your bank may also deduct tax at source when you earn interest from a fixed deposit. The bank deducts TDS at 10% on FDs usually. A 20% TDS is deducted when the bank does not have your PAN information.

  1. Form 16

Form 16 is a TDS certificate. Income Tax Department mandates all employers to deduct TDS on salary and deposit it with the government. The Form 16 certificate contains details about the salary you have earned during the year and the TDS amount deducted.

It has two parts: Part A with details about the employer and employee name, address, PAN and TAN details and TDS deductions.

Part B includes details of salary paid, other incomes, deductions allowed, tax payable.

  1. Form 26AS

Form 26AS is a summary of taxes deducted on your behalf and taxes paid by you. This is provided by the Income Tax Department. It shows details of tax deducted on your behalf by deductors, details on tax deposited by taxpayers and tax refund received in the financial year. This form can be accessed from the IT Department’s website.

  1. Deductions

The lower your taxable income, the lower taxes you ought to pay. So be sure to claim all the tax deductions and benefits that apply to you. Section 80C of the Income Tax Act can reduce your gross income by Rs 1.5 lakhs. There are a bunch of other deductions under Section 80 such as 80D, 80E, 80GG, 80U etc. that reduce your tax liability.