Tax Free Bonds: Should you be investing in them?

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In India there are 2 types of bonds through which the tax liability of a person can be reduced:-

  1. Tax Free Bonds
  2. Capital Gain Bonds

Tax Free Bonds are the bonds on which the interest received is fully exempted from tax under Section 10. However, the principal amount invested in these bonds cannot be claimed as a deduction from the total income of the bondholder for the purpose of payment of income tax.

Capital Gain Bonds are the Bonds on which the interest received is not exempted, however the amount that is invested in these bonds can be claimed as an exemption from Capital Gains under Section 54EC

Tax Free Bonds

These bonds required approval of the central govt before issuance and the interest received on Tax Free Bonds is 100% exempted from the levy of income tax under Section 10 (15)(iv)(h) of the Income Tax Act.

tax-free bond

Although, the interest received is exempted, it would still be required to be disclosed in the income tax return as exempted income.

The interest received on tax free bonds is slightly lower than the interest received on normal bonds. However, if you compare the after tax returns, tax free bonds are better than normal bonds as no tax is required to be paid on interest earned from these bonds.

As the interest received from these bonds is tax-free, these bonds are highly advisable for taxpayers who fall in the higher slab categories of 20% & 30%.

This can be explained with the help of an example:-

Particulars

Normal Bonds

Tax Free Bonds

20%

30%

20%

30%

Amount invested

Rs 1000

Rs 1000

Rs 1000

Rs 1000

Interest Rate (assumed)*

10%

10%

10%

10%

Interest earned

Rs 100

Rs 100

Rs 100

Rs 100

Tax on interest earned

20

30

Nil

Nil

After tax returns

Rs 80

Rs 70

Rs 100

Rs 100

*For the purpose of simplicity, flat 10% interest rate has been assumed for both Normal and Tax Free Bonds. In practice, the interest earned on tax free bonds is slightly lower than the interest earned on the normal bonds.

For issues of tax free bonds expected to be opened in the near term, refer this link.

Redemption of Tax Free Bonds

These tax-free bonds also come with a lock-in period of 10-20 years. The amount invested in these bonds is not paid back before the end of the lock-in period.

However, these bonds are free traded on the stock exchanges and a bond-holder can sell these bonds to some other person but not to the authority issuing these bonds. The gains (if any) on sale of these bonds would be liable to tax as capital gains under Section 112.

If these are sold before the end of 1 year, the gains would be taxed as per the income tax slabs and in case these are sold after the expiry of 1 year, tax would be levied at 10% of profit (if indexation is not done) and 20% of profit (in case indexation is done)

Moreover, in case these bonds are sold to some other person, the buyer would earn interest reduced by 0.25% to 0.50%.

Difference between Tax Saving Fixed Deposit and Tax Free Bonds

Tax Saving Fixed Deposits are deposits with the banks for a minimum duration of 5 years and can be claimed as a deduction under Section 80C. Only the principal amount invested in these fixed deposits can be claimed as a deduction and the interest earned on these deposits is liable to tax as per the income tax slab rates.  These fixed deposits can be opened any time during the year with any bank.

A Comparison of Tax Free Bonds and Tax Saving Fixed Deposit have been done hereunder:-

Particulars Tax Free Bonds Tax Saving Fixed Deposit
Deduction under Section 80C
for amt invested
Not Available Available
Option to invest Can only be invested when
the issue opens
Can be invested anytime
during the year
Tax on Interest earned Exempted Taxable
Maturity 10-20 years Min 5 years
Option to sell before maturity Can be sold on Stock Exchanges Cannot be redeemed before maturity

Our Viewpoint: Should you be investing in Tax Free bonds

Tax Free Bonds are a good investment option for individuals looking for safe and fixed returns as the interest rate is good and the returns are also tax free. However, they come with a drawback that their lock-in period is big. Although, the option of selling these bonds on the stock exchanges is always available – but the volume is fairly low for sale-purchase of such bonds in India as a result of which sellers don’t always fetch a good amount for the sale.

Therefore, these tax free bonds are only suited for individuals who are looking for fixed returns in the long term and not in the short term.

A Personal Finance enthusiast, Karan is the founder of charteredclub.com and loves to discuss about Money related matters.