Income tax on Bonus vs. fixed salary

Note: This pertains only to Indian personal income tax laws.
Do you know that your bonus payout is taxed at a different rate than your fixed (monthly salary)?
Here is how:
Your bonus is always taxed at your highest tax bracket, while there are various exemptions available which are tax exempt.

  1. Your HRA would be 40-50% of your basic. This is tax exempt if you have the proper rental receipts.
  2. Employer’s contribution would be 12% of your basic which does not even show up in your IT records.
  3. Based on company policy your LTA would be a % of your basic which is also tax exempt. (Say 2%)
  4. There are telephone reimbursements, fuel, company car lease and other mechanism that are tied to your basic pay on which you can save taxes.

So 50-64% of your basic salary is tax free. Assuming your basic compensation is 50% of your gross compensation (may vary based on company policy) this translates into 27-32% of your fixed salary being tax exempt.
This means that rather than a popular myth of income tax being 30%+ surcharge, your effective income tax on any increments (in your fixed salary) would be mere 20-22%
IT department is not so kind with bonus: So 1L of bonus taxed at 30% leaves you with 70K, while 1L of additional fixed salary would leave you with 80K extra take home. (~15% higher)
Other merits of having high fixed salary (rather than bonus):

  1. Since fixed salary is paid out monthly (rather than yearly/periodically), it eases your liquidity and ability to meet your regular expenses esp. home loan EMI.
  2. Some cheap companies show bonus as Maximum pay-out to employee rather than the normal. Which means that 15-25% of your bonus never reaches you.
  3. If you quit your job in the mid-year, no private company pays you your due share of the bonus. Hence it’s always beneficial to minimize the receivables.
  4. Gratuity/severance payouts are on the basis of your fixed
  5. Your bank loan eligibility limit is determined on your monthly take home. So high fixed component makes it easier to buy that bigger car/home that you always dreamed of.
  6. Also its beneficial to prepay the loan with a higher EMI, rather than using Bonus to pre-pay (as there are pre-payment penalties etc which you can avoid)
  7. At 9% interest rate, and assuming that the bonus is paid annually at the end of the year, you would lose about 4.5% as interest/time value of money alone. Again some cheap companies will wait for a full quarter before the bonus is paid our. (i.e. the Bonus is evaluated on your performance Jan 2015-Dec 2015 but paid on 1st April 2016.)

Bonus payouts are also not without merits:
1 Since bonus is often tied to the performance levels (personal + team + corporate), there is usually a very high chance to achieve higher bonus.
2 Being paid as a lump sum amount, it is a great morale boaster. It really helps you make the purchase/investment that you always wanted to.
3 Many companies use bonus as a retention tool, as employees usually wait till the Bonus payouts before expressing their desire to quit. Hence lesser value of the bonus, the more control you would have over the timing of the exit.
Hence don’t fall into the CTC (cost to company) trap; always calculate your salary on the basis of BTE (Benefit to employee) basis. A 119% bonus payout at the end of the year is financially equivalent to the same amount being added to your fixed salary. (15% +4.5%)


Quitting job: Reduce your Income-Tax arrears

Most companies assume that you would be employed for the full financial year when you file the income tax returns. However often because of higher education (MBA), marriage or due to foreign opportunities the Income tax computation goes haw-wire. What makes things worse is that getting a refund is practically impossible and takes several years. So here are few tips to help you.
1. Be proactive: One of the primary reasons why Income Tax deducted by the employer is high is because the person had not communicated his/her intentions to the accounts department well in advance.
2. Collect all bills. Certain expenses like communications and medical reimbursements, LTA, company expense account etc which were incurred are tax deductable only if the employer’s form 16 reflects it. So don’t be lazy in submitting these bills.
3. India is in a progressive taxation environment. As a result as the income rises, so does the taxation rate. As a result if you are employed for only 6 months, don’t be surprised if your IT goes down by not 50% but 60-70%. This is the major source of IT arrears. There are 2 ways around it.
1. Inform your company well in advance that you would be terminating your employment in the mid year.
2. Reduce your IT projection so that the income tax gets revised downwards. This can be done by claiming for all the tax reliefs possible, even if it is fictitious. You can file that you intend to take a home loan (50,000/- tax relief) or donate money in one of the tax exempt funds. This will reduce your tax liabilities and IT arrears.
PS: Please consult your tax consultant.


Direct vs indirect taxes

All the developed countries tax the income (direct taxes), rather than the expenditure (indirect taxes).
Reason: It is easier to introduce tax slabs or progressive taxation rates so that the rich pay a higher proportion of their income as taxes. The poor spend a higher portion of their income on food and basic necessities while the rich are able to save and reinvest bulk of their surplus. Hence by taxing good and services the country ends up taxing poor more than the rich. VAT discourages consumerism, and hence slows down economic growth.

However it’s easier for an underdeveloped/developing society to tax the goods than income. The reason behind that is to be effectively able to collect direct taxes you need a sound financial reporting and auditing else there will be pilferage. What is worse is that there will be a situation like it exists in India where the middle/service class end up paying a much higher percentage of their income as taxes than the rich who through hiding their income or via various tax shelters hardly pay any.

One of the important learning/change in viewpoint that happened after my stay in France is that now I understand how the corruption rots the entire system and makes the society worse off. Sometimes end does not justify the means and corruption is one of the instances.



Income Tax: Pay Commission

Because of Sixth Pay Commission report implementation, a lot of government and PSU employees on India are getting substantial backwages. This lumpsum payment has resulted in a substantial tax payout for even the lowest paid employees. Not only now these individuals fall under the higher tax slabs, but most of the officers need to pay a surcharge on their income tax (which typically was paid only by the highest paid private sector employees)

However, I was talking to my tax consultant and he said that if an individual has preserved all his tax papers, then there is a way out.
Pay Commission Arrears are payouts of the income withheld by the employer (Government). Hence they are technically income generated in the past years. Hence the individuals can submit a revised income tax documents and correct (increase) their salary in the previous years to reflect the new pay commission pay scales. Doing so they can avoid landing up in the highest tax slab for the financial year 2008-2009.

More details about the Sixth Pay Commission and official notifications/circulars on the same can be found here.

PS: Please consult your tax consultant for further details.