How to Calculate Income Tax on Salary: Step-by-Step Guide with Examples (AY 2026-27)

Your employer deducts TDS from your salary every month, but do you actually know how that number is calculated? Understanding the full computation — from gross salary to the final tax you owe — helps you verify your Form 16, choose the right tax regime, and plan deductions before the year ends.

This guide walks through each step of the income tax calculation for salaried individuals, with a realistic example worked out under both the old and new tax regimes for AY 2026-27 (FY 2025-26).

The Nine Steps to Calculate Your Tax

Here is the high-level flow before we dive into each step:

1. Compute Gross Salary
2. Subtract exempt allowances (old regime) or skip (new regime)
3. Apply standard deduction
4. Add income from other sources (interest, rent, etc.)
5. Subtract Chapter VI-A deductions (old regime) or limited deductions (new regime)
6. Arrive at total taxable income
7. Apply tax slab rates
8. Claim rebate under Section 87A if eligible
9. Add 4% health and education cess

Let us walk through each step using the profile of Priya, a 30-year-old software engineer in Bengaluru earning Rs 18,00,000 per year.

Priya's salary breakup:

Priya lives in a rented apartment paying Rs 25,000 per month (Rs 3,00,000/year). She has investments in ELSS (Rs 1,50,000), health insurance for herself and parents (Rs 50,000), and an education loan EMI with Rs 40,000 interest component.

Step 1: Compute Gross Salary

Gross salary is your total earnings before any deductions or exemptions. It includes Basic, HRA, Special Allowance, LTA, and bonuses. It does not include the employer's PF or NPS contributions (these are handled separately).

Priya's Gross Salary: Rs 7,20,000 + Rs 3,60,000 + Rs 5,40,000 + Rs 60,000 = Rs 16,80,000

Step 2: Subtract Exempt Allowances

This step differs entirely based on your tax regime.

New Regime

Under the new regime, almost no allowance exemptions are available. HRA exemption, LTA exemption, and most Section 10 allowances cannot be claimed. Skip this step — your salary stays at Rs 16,80,000.

Old Regime — HRA Exemption

The HRA exemption is the biggest salary exemption most people claim. It is the lowest of three amounts:

1. Actual HRA received: Rs 3,60,000
2. Rent paid minus 10% of Basic: Rs 3,00,000 − Rs 72,000 = Rs 2,28,000
3. 50% of Basic (metro city): Rs 3,60,000

HRA exempt: Rs 2,28,000 (the lowest)

Priya can also claim LTA exemption of Rs 60,000 if she has travel bills.

Salary after exemptions (Old Regime): Rs 16,80,000 − Rs 2,28,000 − Rs 60,000 = Rs 13,92,000

Step 3: Apply Standard Deduction

Every salaried taxpayer gets a flat standard deduction — no bills or proof required.

After standard deduction:

• New Regime: Rs 16,80,000 − Rs 75,000 = Rs 16,05,000
• Old Regime: Rs 13,92,000 − Rs 50,000 = Rs 13,42,000

Step 4: Add Other Income

If you earn interest on savings accounts or fixed deposits, receive rental income from a second property, or have any other income, add it here. For simplicity, assume Priya earns Rs 30,000 in savings account interest.

• New Regime: Rs 16,05,000 + Rs 30,000 = Rs 16,35,000
• Old Regime: Rs 13,42,000 + Rs 30,000 = Rs 13,72,000

Step 5: Subtract Deductions

New Regime

Under the new regime, very few deductions are allowed. The key ones still available:

• Employer NPS contribution under Section 80CCD(2): Up to 14% of Basic (central government) or 10% of Basic (others). Priya's employer contributes Rs 33,600 — fully deductible.
• Section 80JJAA (new employment deduction) — applies to employers, not usually to individuals.

Taxable income (New Regime): Rs 16,35,000 − Rs 33,600 = Rs 16,01,400

Old Regime

Under the old regime, you can claim the full suite of Chapter VI-A deductions. Here is what Priya claims:

Note: The Rs 10,000 deduction under 80TTA effectively cancels out the savings interest added in Step 4.

Taxable income (Old Regime): Rs 13,72,000 − Rs 2,83,600 = Rs 10,88,400

Step 6: Apply Tax Slab Rates

New Regime Slabs (AY 2026-27)

Priya's taxable income: Rs 16,01,400

Old Regime Slabs (AY 2026-27)

Priya's taxable income: Rs 10,88,400

Step 7: Check Rebate Under Section 87A

The Section 87A rebate wipes out your entire tax liability if your taxable income is within the threshold:

Priya's taxable income exceeds the threshold in both regimes, so no rebate applies for her.

However, if your income is close to these thresholds, the rebate can completely eliminate your tax. For salaried individuals under the new regime, a gross salary up to approximately Rs 12,75,000 (Rs 12 lakh + Rs 75,000 standard deduction) results in zero tax.

Step 8: Add Health and Education Cess

A 4% cess is added on top of the tax amount. This funds public health and education programmes and cannot be avoided.

• New Regime: Rs 1,20,280 × 4% = Rs 4,811 → Total tax: Rs 1,25,091
• Old Regime: Rs 1,39,020 × 4% = Rs 5,561 → Total tax: Rs 1,44,581

Step 9: Compare with TDS Already Deducted

Your employer deducts TDS from your salary every month based on their estimate of your annual tax. After computing your actual liability:

• If TDS deducted > actual tax, you get a refund
• If TDS deducted < actual tax, you owe self-assessment tax

You can verify TDS deducted by checking Part A of your Form 16 or your Form 26AS/AIS.

Priya's Final Comparison

For Priya, the new regime saves approximately Rs 19,500 despite giving up HRA, LTA, 80C, 80D, and 80E deductions. This is because the wider slabs and lower rates under the new regime more than compensate for the lost deductions at her salary level.

This will not be true for everyone. If your deductions under the old regime exceed Rs 4-5 lakh (common if you have a large home loan interest component under Section 24(b) or significant NPS contributions), the old regime could still save you more. Run the numbers for your own situation before choosing — or use 49Tax's AI-powered regime comparison to see which one minimises your tax with your actual salary and deductions.

Common Mistakes to Avoid

Forgetting to add other income. Savings interest, FD interest, or freelance income must be included in your total income. Omitting these can trigger a mismatch when the department cross-checks with your AIS.

Double-counting employer PF under 80C. Your 80C limit is Rs 1,50,000 in total. If your employee PF contribution is Rs 86,400, you only have Rs 63,600 left for ELSS, PPF, insurance premiums, and other 80C investments.

Ignoring the regime choice deadline. Salaried employees can switch between old and new regime every year at the time of filing. But you must inform your employer early in the year if you want TDS deducted under a specific regime — otherwise they will default to the new regime.

Not checking for surcharge. If your taxable income exceeds Rs 50 lakh, a surcharge of 10% on the tax amount kicks in (higher percentages apply at higher income levels). This guide covers incomes below that threshold, but if your income is higher, factor in the surcharge before the cess calculation.

Key Takeaway

Calculating income tax on salary is a sequential process: gross salary → exemptions → standard deduction → other income → deductions → slabs → rebate → cess. Once you understand each step, you can verify your Form 16, make informed regime choices, and plan investments before the year ends rather than scrambling in March. If you want to skip the manual arithmetic, 49Tax can extract your salary details from Form 16 and compute the optimal tax under both regimes in minutes.