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It is common to see people search for investment options that offer them tax exemptions and, thereby, great financial returns. In India, Tax Free Bonds are issued by the Government for attracting investments from the general people. In return, the government gives benefits to investors in the form of tax savings. These bonds are good low-risk investment plans.
Tax Free Bonds are those types of goods or financial products, which the government issue. They offer you a fixed interest rate and hence are low-risk investment option. This is covered under Section 10 of the Income Tax Act of India, 1961. The government invests the capital collected from these bonds in infrastructure and housing projects.
Tax Free Bonds are long duration bonds, typically maturing after 10, 15 or 20 years. So make an ideal inclusion in the retirement portfolio.
Let us take the example of A and B who both earn Rs. 15 lakhs per year. A invests Rs. 1 lakh in a fixed deposit fetching him 9% p.a for 1 year. B, on the other hand, invests Rs. 1 lakh in a tax free bond at 8.26% p.a. for 10 years. They both come under the highest tax bracket of 30%. Let’s see how their taxable income will differ:
| A (Invested in FD) | B (Invested in Tax Free Bonds) | |
|---|---|---|
| Annual income | 15,00,000 | 15,00,000 |
| Investment | 1,00,000 | 1,00,000 |
| Interest Earned | 9,000 (9%) | 8,260 (8.26%) |
| Tax, on interest, at 30% | 2,700 | — |
| Balance interest Income | 6,300 | 8,260 |
| Rate of Interest after Taxes | 6.3% | 8.26% |
Eligibility to Invest
Tax Free Bonds are an excellent option if you are looking to earn a fixed annual income from the interest generated from the bonds. Remember that your investment will get locked in for an extended maturity period of at least 10 years. Hence, such bonds are best suited if you have a low-risk profile with the ability to afford a long-term lock-in period.
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As per the rules and regulations stated under the Disclosure and Investor Protection Guidelines, defined by SEBI. Thereby making Limited Liability groups and Partnerships eligible to invest in Tax Free Bonds. Other regular investors in these bonds could be entities such as co-operative and regional banks, trusts and corporates.
- Retail Individual Investors (RIIs) – Including Non-Resident Indians (NRIs) and members of the Hindu undivided family (HUF).
- Qualified Institutional Buyers (QIBs) – these have been defined under the SEBI (Disclosure and Investor Protection) Guidelines, 2000.
- High Net-worth Individuals (HNIs) – those with a low-risk appetite and can invest up to Rs. 10 lakhs.
Corporate, trusts, co-operative banks, regional rural banks. They are hugely popular with HNIs because they allow investing a lump sum in one place. They are regarded to be relatively safe as, principally, they are issued by government institutions and carry high investment grade ratings. Also, the effective pre-tax yield is high for those in the higher income slab.
They may also be a preferred option for those who want to diversify their portfolio by investing in alternative investment funds.
Characteristics of Tax Free Bonds
The following are the main characteristics of Tax Free Bonds. These include the essential benefits that an investor is offered for saving in these.
Liquidity
Unlike debt funds, an investor of tax free bonds cannot liquidate them easily. The reason is that government bonds come with more extended lock-in periods and are generally long-term investment plans. Hence, these cannot be treated as funds to be used in an emergency.
Interest
As per the current rates, these bonds offer an approximately 6.5% rate of interest for its investors. This is rather attractive especially if you are doing your income tax planning and looking for tax exemption. A bondholder would receive interest annually. However, the rate of interest is subject to fluctuations because they depend on the current rate of government securities.
Tax Exemption
The income that is generated in the form of interest is completely free from income tax of any sort. They are also exempt from tax deducted at source. However, this does not mean that the investment amount can be claimed. Or that the interest doesn’t need to be declared. Every bondholder must declare the interest they receive as income. Tax Free Bonds offer a wide range of great benefits. Especially to those investors whose income falls under the high tax bracket. Specifically when compared to Fixed Deposits offered by banks.
They are listed on the stock exchange, i.e. NSE & BSE-Sensex, after they have been issued. The purpose is to provide an easy exit for the investors.
If someone does opt for redeeming, in that case, any profit generated from the sale of these bonds on stock exchanges is liable to tax.
Lock-in Duration
These Bonds come with a very long lock-in period that lasts from 10 to 20 years. The invested amount cannot be withdrawn before the bonds you hold get mature.
Risk Element
These are government bonds. Therefore, the chances of defaulting on an interest payment are too low. Because the government itself is starting these schemes, hence, it is quite safe to invest in them as they offer a fixed annual income and capital protection.
Issue Transactions
The government issues these bonds using a Demat account or in physical mode. These may get traded in the stock markets. Hence, the interest earned on these bonds is entirely tax-free. But, the capital gain received by selling these bonds in stock markets is taxable.
Comparison with the Market
The returns that are obtained from these bonds are largely dependent on the price they will get. Because these get traded with only a limited number of buyers or sellers who are interested. Also, the volume is quite low and available only when the government issues them.
Entities that Offer these Bonds
Many public undertakings are allowed to offer and issue tax-free bonds.
- National Highway Authority of India,
- NTPC Limited,
- Indian Railways,
- Rural Electrification Corporation,
- Housing and Urban Development Corporation,
- Indian Renewable Energy Development Agency,
- Rural Electrification Limited, and
- Power Finance Corporation are some of the widely known ones.
You must always thoroughly check the authenticity before buying.
Investing in Tax-Free Bonds
Tax-Free Bonds provide the facilities for trading. Therefore, the investors are permitted to trade bonds through a Demat account or in a physical form. Availing the various benefits of investing in these Bonds is simple and will ear you high rewards. However, do note that the subscription period for the investment would be open only for a specific period. You are required to submit a copy of your PAN and get your KYC done while purchasing a physical format of these bonds.
Afterward, you may trade by applying, online or offline. Whereas, if you are applying for a bond after the issue period is over, you may invest using a trading account. This feature is the point of differentiation between the Bonds and shares in the equity markets.
Redemption of Tax-Free Bonds
It is quite easy to redeem Tax-Free Bonds once the maturity tenure is over.
Although, it is not possible if you wish to withdraw the money before this pre-determined maturity tenure. However, you may choose to trade them on stock exchanges to sell to another buyer or investor. It should be noted that the person who sold the bonds initially, would not be able to buy back the said bonds as well. In case, you sell it within 12 months, then the profit that is earned from selling these bonds is deemed taxable under Section 112. In other words, the gains generated from selling the Tax-Free Bonds before the completion of a year are considered taxable. the tax will get charged as per the income tax slab applicable to your income. Trading these bonds after a year has elapsed, without indexation, would attract a rate of 10.30% of long term capital gains (LTCG). The tax would get raised to 20% after a year with indexation.
Comparison Between Tax-Free Bonds and Tax Saving Bonds
It is common to get mixed up between Tax-Free Bonds and Tax Saving Bonds. And consider both as the same. However, they are quite different. Below are the main points of differences between the two.
| Tax-Free Bonds | Tax Saving Bonds | |
|---|---|---|
| 1. | The rules and regulations regarding these bonds are stated under Section 10 of the Income Tax Act. | The rules and regulations regarding Tax Saving Bonds are stated under Section 80CCF of the Income Tax Act. |
| 2. | The Interest Income received from these bonds is exempt from any taxes. | For Tax Saving Bonds, only the initial investment gets exempted from taxes. |
| 3. | No Maximum limit for investment. | The exemption for the tax is only applicable for investments up to Rs 20,000. |
| 4. | Tax Free Bonds have higher rates of interest as compared to those offered by Tax Saving Bonds. | Lesser rates for interest when compared to Tax-Free Bonds. |
| 5. | Lock-in duration is high, starting from 10 years. | An investor can withdraw the investment after a tenure of 5 or 7 years. But the buyback clauses are complex. |
Final Notes
Conclusively, if you are looking for investment options through which you can claim tax benefits this financial year. From life insurance to repayment of education loans, a lot of such investments are exempt from tax. However, in case you are looking for further tax-saving options, you can invest in Tax-Free Bonds. These are quite popular tax saving investments among the public.
They are especially favored for retirement plans. For they give fixed tax-free income at low risk. They may be redeemed via trading of these bonds in secondary markets before the maturity period. However, the government hasn’t issued any new bonds since 2016. So, you need to be aware of tenure and interest rates if you are considering those by PSU companies.
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