Investors apart from risk and return of investments are usually more interested in gaining tax benefits from an investment. In order to reduce the tax liability people mainly invest in either tax free bonds or capital bonds. Lets delve into discussion on whether one should really invest in tax free bonds or should keep their hands away from these bonds.
What are Tax free bonds?
These are the bonds on which you do not have to pay any tax on the interest received from it. That is, the interest received from these bonds is exempt from tax under section 10 of Income Tax Act. But the principal amount that has been invested in these bonds is not eligible to be claimed as deduction from the total income of the person holding the bond. Before issuance of the bond, it is mandatory to get an approval from the Central Government then only the bond can be issued.
Return from tax free bonds
Bondholders will get interest on the amount invested in these bonds. However, it must be noted that the interest received from tax free bonds is somewhat lower in comparison to the interest received from investment in other bonds. But if you set the comparison between these bonds and other bonds in terms of after tax returns, then surely the return from tax free bonds will be on higher side. This is so because the tax free bonds offer the interest that is fully exempt from income tax. One can invest in these bonds only when the issue is open.
Who should invest in these bonds?
As it has already been mentioned that bondholder will not be required to pay any tax on the interest received from these bonds, it is highly recommended for those persons who fall in 20% or 30% tax bracket. This will result in income to them without enhancing their tax liability. Let us see this with the help of an example –
Suppose a person falling under the tax bracket of 20% has invested Rs. 1,000 in normal bonds or fixed deposits yielding say 8.5% return ( which is quite optimistic in today’s scenario). Interest received from these bonds will be Rs.85, on which Rs. 17 will be charged as tax (since the tax bracket is 20%). Therefore, after tax pr post tax interest income will be Rs. 68.
Now, let us say, that another person B who also falls in 20% tax bracket has invested Rs. 1,000 in tax free bonds yielding 7.5% return. Interest received from these bonds will be Rs. 75 and since these bonds are tax free, the after tax return will remain same at Rs. 75, which is definitely more than the post tax returns from normal bonds.
When can tax free bonds be redeemed?
For these tax free bonds, the lock-in period is 10 – 15 years. Therefore, the amount invested in these bonds is not repaid before the expiry of lock-in period. However, these bonds are traded in stock exchanges. Any gains on the sale of these bonds would attract capital gains tax. In nutshell, liquidity is not the major issue in case of tax free bonds. One important point should be noted here, if these bonds are sold then the buyer of these bonds will get 0.25% to 0.5% less interest from what has been offered initially.
How tax free bonds are different from tax saving fixed deposit?
Tax saving fixed deposits is the deposits with the banks. The lock-in period is 5 years. Tax deduction is claimed under section 80C for tax saving fixed deposits. Though the principal amount of deposit is eligible for tax deduction, interest earned from these deposits is attracts tax liability as per the slab rates of income tax. Unlike tax free bonds, tax saving fixed deposits cannot be traded in stock exchanges. You can invest in tax free bonds only when the issue is open but investment in tax saving fixed deposits is open round the year.
Conclusion: If you are looking for an investment alternative which is secure, can yield good returns and the returns from the investment should not increase your tax burden, then tax free bonds will perfectly suit your requirement. However, the only detriment of investing in tax free bonds is the big lock-in period. Though you have an option to trade them on stock exchanges but the liquidity is low as the volume traded on stock exchanges for these bonds is on lower side. Therefore, if you are ready to wait for a long period of time, then tax free bonds can surely be one of your best choices.
