Create tax-free income for your child

A child can start earning from the day he is born. Someone can open a fixed deposit account in his name. That can be followed up with insurance policies, mutual fund schemes, real estate investments, and what have you.

Now if a child is capable of owning assets, argues the taxman, there is no reason why he should not be paying taxes too.

Since assets and income are actually being created on behalf of the child, taxes, too, have to be paid on his behalf. And the onus of doing so, according to the Income Tax Act, is on the parent with the higher annual income -- the income of a minor child will be clubbed with his.

The implication is simple: if you are trying to create assets for your child, try to ensure that the income from them is tax-free. And, for whatever it is worth, the I-T Act allows a deduction of Rs 1,500 per child from such clubbed income of a parent.

According to Lovaii Navlakhi, managing director and chief financial planner, International Money Matters, while it does not matter from the tax point of view whether the money is invested in the name of the parent or the child, it is still a great idea to create assets in a child's name. That's because parents are loath to withdraw investments for short-term needs if they are in the name of their child.

When the child is a minor, the interest earned on investments made in his name is taxed on accrual basis even if it is not realised. In most cases, that would be annually.

Take National Savings Certificates, for instance. While the only payout is when the certificate matures, interest accrues annually. So, every year, the interest amount will get added to your income. It is important to keep this interest payout in mind when investing for your child.

So, what are the investments you can make for your child that will provide tax-free income? Equity mutual fund units are a good option. Another is a Public Provident Fund account. Dividends in the first case and interest in the second are tax-free and, therefore, will not add to your tax liability.

Gifts, in general, should be avoided. If you or anyone else gives your child a gift, it will be taxable in your hands because of income clubbing. But there are exceptions. Inheritances are not taxed in the hands of the recipient.

Nor are gifts given by a 'close relative' out of 'natural love and affection'. Relatives include brothers and sisters, brothers- and sisters-in-law, maternal and paternal uncles and aunts, lineal ascendants and descendants and their spouses. Also, make sure that there is no consideration for the gifts received.

If a child's income continues when he has ceased to be a minor, he would have to file tax returns, even if his only earning is income from sources other than business or salary. He should also get a PAN number.

Snapshot

• The parent who earns more annually pays tax on behalf of a minor child -- their incomes are clubbed
• MF dividends and PPF interest are tax-free, so if your child earns these, your tax liability doesn't rise
• Inheritances are not taxed in the hands of the kid