Tax Exemption Vs Tax Deduction

If you’ve been foxed by the differences between some common financial terms, you’re not alone. For many years I was confused between the two terms "Tax Exemption" and "Tax Deduction". It all looked the same to me. Understanding the difference is critical to calculate your true tax liability as well as filing the right Income Tax Returns every year...Read on..

Both "Tax Exemption" and "Tax Deduction" are options to reduce tax liability but are availed of in entirely different ways under different sections of the Income Tax Act. Let us understand each one of them in detail.

Tax Exemption

This is the amount that is excluded or removed from the gross total income, much before your Income Tax Bracket is decided or your tax is calculated. As the name suggests, this income is an income which is "exempted" from any kind of tax.

1/ The benefit of Tax Exemption is available only from a specific source of Income, and not from the Gross Total income. e.g. no Tax Exemption is allowed if you source of Income is Salary.

2/ Under Income Tax Laws, the benefit of Tax Exemption is applicable only under Section 10 and Section 54 of IT Act. Thus, if you have earned money through a specific source like tax free bonds, then only you can claim "Tax Exemption".

3/ Some of the typical tax exemptions include Leave Travel Allowance, interest from tax-free bonds, or long-term capital gain on equity funds, among others.

4/ After taking care of "Tax Exemptions" from your "Gross Total Income", what you arrive at is the "Taxable Income".

5/ Tax Exemptions usually do not have a limit e.g. Long Term Capital Gains from sale of stocks or equity mutual funds are all exempted from your Gross Total Income for tax calculation purpose - irrespective of the amount.

Tax Deduction

Tax Deduction is applied while calculating your taxes and after you have taken care of all Tax Exemptions i.e. it is applied on your "Taxable Income".

1/ Tax Deduction can be claimed irrespective of your source of Income. So, you claim Tax Deductions on your money even if it was earned from your Salary or any other source which does not qualify for any exemption.

2/ This refers to the reduction or deduction in the total taxable income through benefits availed of under Section 80 (80C to 80U). Your investments or spending done under the respective sections are then "deducted" from your Taxable Income to arrive at your "Net Taxable Income"

3/ In one way, the income is first added to the "Gross Total Income" and then "deducted" from it.

4/ Some typical examples for income which is applicable for Tax Deduction are 1.5 lakh under Section 80 C - which is available if you invest in particular life insurance policies or spend on children’s school tuition fee, among other avenues.

5/ Tax Deductions usually have a limit e.g. Rs 1.5 Lacs is the limit for Section 80C, similar limits exist for Section 80D. 

The below picture will help you clearly distinguish where these two categories are applied:

 

Understanding the difference is vital to estimate the right amount of tax to be paid, and the right source of Income on which it can be applied.

Cheers

Manoj Arora
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