If You Have A Home Loan, Which Tax Regime Should You Choose?

From 2020-21, you have the option of planning your taxes based on one of the two tax regimes. The new tax regime, for which you will file your returns in AY2021-22, allows you to pay a lower rate of tax. But to avail it, you must forgo your tax deductions such as those under Sections 80C, 80D, and 24B. You could, of course, claim those deductions by remaining in the old regime but you’ll have to pay a higher tax rate there.

At lower levels of income, the choice may be straightforward. You don’t need to pay any income tax if your taxable income is Rs 5 lakh or less. Even at a slightly higher income, if you don’t want the hassle of tax savings and want to enjoy a higher disposable income, the new regime may be the one for you.

However, if you have committed to tax-saving measures, such as a home loan, life and health insurance, provident fund, NPS and others, the choice is more complicated.

Some of these instruments are critical to your finances because they serve a larger function than just tax deductions. Giving them up isn’t an option. At the same time, is remaining in the old regime in your best interest? After all, your tax outgo may be simply lower in the new regime. How do you decide?

Who should stay in the old regime

The old regime with its higher tax rates is for those committed to various tax-saving measures. A home loan is one of the easiest ways to get sizeable tax deductions. All taxpayers are eligible for deductions up to Rs 1.5 lakh under Section 80C and up to Rs 2 lakh under Section 24B for principal and interest paid, respectively.

Eligible borrowers can get further deductions for their home loans under Sections 80EE or 80EEA.

Given that your home loan may be providing you deductions of more than Rs 2 lakh a year in many cases, and upwards of Rs 4 lakh in some rare cases, there may be a case for you to remain in the old regime. To make the case, you must do the math. 

Use the 20% formula

To simplify the decision making process of the old versus new regime, you can apply the 20 per cent formula. Check if all your tax deductions combined are 20 per cent of your income. So, for example, if your income is Rs 10 lakh, your various deductions combined should be at least Rs 2 lakh. Even before you take a home loan, buy insurance or make tax-saving investments such as PPF, you may be eligible for several deductions.

For example, all individual tax-payers are eligible for a standard deduction of Rs 50,000. Apart from this, you may claim deductions for such items as your office PF contributions, children’s tuition fees or rent. All put together, do your deductions reach 20 per cent of your income? If so, you should remain in the old regime.

As Table1 demonstrates, at all levels of income, the old regime is better if you can get 20 per cent deductions. Do note this is merely a rule of thumb. You must refer to your particular income numbers to understand what is best for you. Use an online tax calculator to understand the numbers.

How home loan helps

Your home loan provides you a way to streamline your tax deductions. With it, you can get a large deduction of up to Rs 3.5 lakh under 80C and 24B. If you can hit the Rs 1.5 lakh limit under 80C with your principal paid, you don’t need additional tax-saving investments — and, therefore, you can also avoid the often messy trail of paperwork and proofs.

If you’re falling short of the 80C limit with your principal payments, you could simply prepay your home loan to that extent.

Your home loan deductions put together with your standard deduction (16IA) health insurance (80D), NPS (80CCD1), LTA [10(5)], education loan (80E), donations (80G) and others may bring your total deductions to 20 per cent.

If you’re falling short, you can invest higher. If you cannot invest higher, you may be better off forgoing all deductions and opting for the new regime.

Who won’t benefit from old regime

At higher levels of income — let’s say upwards of Rs 20 lakh — the caps on deductions may make it difficult to reach the 20 per cent mark. Even home loan deductions taken to the fullest may fall short. But this can only be ascertained once you’ve done the math by calculating your tax liabilities in either regime.

You may find that the new regime works best for you despite the heavy contributions you are making towards your home loan.

Picking the right regime could save you thousands of rupees. When in doubt, speak to a tax adviser.

This article originally appeared in The Telegraph. 

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