Tax-Free Bonds Vs. Tax-Saving Bonds: Which One Should Be Your Pick?
Introduction
The start of the fiscal year brings the search for tax-saving investment opportunities. Of all the government-issued options that exist, the two most popular are tax-free bonds and tax-saving bonds. It is a common practice to use the investment terms "tax-free bonds" and "tax-saving bonds" interchangeably. However, these two are quite different regarding their features and manner of tax benefits as per the Income Tax Act, 1961.
Let us understand the difference between the two and how these can help reduce the tax burden.
Tax-Free Bonds
Tax-free bonds are a government-backed, fixed-income investment option in which the interest received by the bondholders is entirely tax-free.
Who Issues Tax-Free Bonds?
Government entities with a low risk of default, such as public sector undertakings, infrastructure companies, and municipal corporations, issue these bonds. Some entities that issue tax-free bonds in India are NHAI, IRFC, REL, NTPC, REC, NABARD, IREDA, PFC, and HUDCO.
What Are The Benefits Of Tax-Free Bonds?
The key benefit of Tax-free bonds is that the interest income received on these bonds is exempt under Section 10(15) of the Income Tax Act. Thus, there is no TDS deduction for the interest payable on tax-free bonds. It is important to remember that while the interest on such bonds is tax-free, the investment amount cannot be claimed as a deduction under section 80C of the Income Tax Act.
It is important to note that tax-free bonds have a long maturity period, say 10, 12, or 20 years. Therefore, these are a good pick for long-term investors.
How To Buy Tax-Free Bonds?
One can purchase tax-free bonds from the secondary market through the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE) through their Demat account.
Tax-Saving Bonds
While tax-free bonds benefit from a tax on the interest amount, tax-saving bonds benefit from a tax on the investment amount, i.e., the investment amount in such bonds (up to a limit) is deducted from taxable income. This helps reduce the individual's total tax liability. Tax-saving bonds can fall into one of the categories mentioned below in the Income Tax Act, 1961.
1. Tax-Saving Bonds Under Section 80CCF
This section provides an opportunity to reduce taxes by investing in the nation's infrastructure projects up to a maximum benefit of INR 20,000 for an assessment year.
Only resident individuals of India can claim the deduction under this section.
Here is an example to understand the working of Section 80CCF-
Let's take the case of Mr. X, whose yearly income is INR 10 lakhs. According to the prevailing income tax rates, Mr. X has to pay taxes on the taxable income of INR 9.5 Lakhs (after standard deductions of INR 50,000), which turns out to be INR 1.06 lakhs (under the old regime, assuming he is not claiming any other tax benefit).
If he invests in the Tax Saving Bonds, he can further reduce his taxable income by INR 20,000 under Section 80CCF. In this case, the tax on the income would be INR 1.02 lakhs (under the old regime).
2. Capital Gains Exemption Bonds Under Section 54EC
Selling capital assets or properties and making a profit attracts taxes on such profits or capital gains. Section 54EC of the Income Tax Act provides an opportunity to reduce taxes by investing long-term capital gains (other than from shares and securities) in the bonds issued by infrastructure companies.
The bonds issued by the National Highways Authority of India (NHAI), Indian Railway Finance Corporation (IRFC) Limited, Rural Electrification Corporation (REC), or Power Finance Corporation Limited (PFC) are called 54EC bonds.
Some of the points to note for claiming tax benefits under this section are-
- The amount should be invested within 6 months of transfer.
- Assets should be long-term (minimum of 24 months before the sale).
- There is a lock-in period of 5 years.
- The maximum limit for investment in 54EC bonds is INR 50 lakhs for an assessment year.
Here's an example of computation of taxable capital gain after investment in 54EC bonds-
Amount on sale received by Mr. X | INR 50 lakh |
Less: Cost of purchase (after inflation) | INR 30 lakh |
Less: Cost of improvement (after inflation) | INR 5 lakh |
Long-term capital gain | INR 15 lakh |
Less: Investment in NHAI Bonds within 6 months | INR 6 lakh |
Taxable long-term capital gain | INR 9 lakh |
Investors should note that if they realise the investment (of capital gain amount) in cash before maturity, the investment amount becomes taxable as long-term capital gain in the year of encashment.
Major Risk and Liquidity Factors
It is essential to compare tax-free bonds vs tax-saving bonds, as this always helps evaluate the aspects of risks and liquidity better:
Risks
Tax-free bonds are relatively low-risk because they are issued by government-backed entities. Regardless, their market value may decrease if there is an increase in interest. This makes it subject to interest risks.
On the other hand, tax-saving bonds tend to have a credit risk. This depends on the financial stability of the issuing company. These might be slightly more risky compared to tax-free bonds, as they are not always backed by the government.
Liquidity
Tax-free bonds are allowed to be sold before maturity and are listed on the stock exchange. This, in turn, offers higher liquidity.
Tax-saving bonds cannot be redeemed early like tax-free bonds, especially the ones that are under Section 54EC and have a mandatory 5-year lock-in period. This makes them less liquid in comparison to tax-free bonds.
Also Read: Rise In STT After The Budget: What The Securities Transaction Tax Hike Means For Investors
Tax-Free Bonds Vs. Tax-Saving Bonds- Which is Better?
Factors like financial goals, income levels, and investment range should be considered before choosing between tax-free bonds and tax savings bonds.
Investors seeking steady incomes over longer tenures
These investors are better suited for tax-free bonds. This is because tax-free bonds offer fixed, tax-exempt interest income over a span of 10 to 20 years. This can also be traded on exchanges.
Investors seeking short to medium-term plans
These investors should consider tax-saving bonds. This works well in case the investor wants to claim deductions in a current assessment year or in cases where they want to save on capital gains tax.
Investors seeking high investments
These investors should look into tax-free bonds. The reason is, the tax-exempt interest keeps the post-tax return at a higher value in comparison to other instruments.
Here is a table to understand the difference better:
Basis | Tax-Free Bonds | Tax-Saving Bonds |
Applicable section of the Income Tax Act | Section 10(15) | Historically, Section 80CCF only with caveats or Section 54EC |
Lock in | No lock-in period. Investors can sell these bonds in the secondary market anytime | 5 years lock-in. Investors cannot sell the bonds before maturity |
Tenure | Generally, long-term, say 10 to 20 years | Generally medium-term with varied maturity periods, 5, 10, 15, or 20 years |
Tax Benefits | Interest income is exempt from tax, and hence, no deduction of TDS | Investment funds are exempted only if compliances are met. |
Risks | Risks are very low since they are issued by government-backed bodies. | Moderate risks depending on the ratings of the issuer. |
Compatibility | These are ideal for investors seeking high income or secure long-term investments. | These are suitable for investors who want to save tax on their current incomes and capital gains. |
Type of Return | Gives a fixed return and has tax-free interest. | Complies with tax-deduction investments but has a taxable interest. |
Portfolio Planning with Tax-Free and Tax-Saving Bonds in India
Use of tax-free bonds vs tax-saving bonds can be made beneficial within the portfolio by balancing returns, tax efficacy, and safety.
1. Diversified Portfolios: To diversify portfolios, investors should combine tax-free bonds. This will benefit long-term income with equity or growth from mutual funds.
2. Tax Planning: To avoid capital gain tax after selling a long-term asset, investors should consider using the Section 54EC tax-saving bonds.
3. Passive Income or Retirement: During retirement, a steady flow of income is what such investors seek. Hence, tax-free bonds are best suited for these investors as they are a great source of a steady post-retirement cash flow.
Conclusion
Tax-saving bonds offer deductions on the invested amount, while tax-free bonds provide interest that is completely exempt from tax. Indian investors should evaluate factors such as investment goals, risk tolerance, tax implications, and bond maturity before choosing the right option.
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Frequently Asked Questions On Tax-Free Bonds
1. Are tax-free bonds taxed on maturity?
Interest is exempt with tax-free bonds, but capital gains on the sale of tax-free bonds on maturity are taxable under the Income Tax Act.
2. What is the maturity of a tax-saving bond?
The minimum lock-in period is 5 years, and the maturity differs in each bond and could be from 10, 15, or 20 years, depending upon the conditions attached by the issuer.
3. Are tax-free bonds better than tax-saving bonds for high-income investors?
Definitely, tax-free bonds are better than tax-saving incomes for investors seeking higher incomes. This is because the interest earned from tax-free bonds is exempt, resulting in the highest post-tax return.
4. Can NRIs invest in tax-free or tax-saving bonds in India?
Unlike tax-saving bonds such as Section 54EC, which are restricted to residents only, NRIs can invest in a tax-free return, depending on the terms of issue.
5. How do Section 54EC and 80CCF bonds differ in terms of tax benefits?
In the case of Section 54EC, investors are allowed an exemption from long-term capital gains tax of Rs. 50 lakhs (5-year lock-in), only if the investment is made within six months of the sale. Whereas, for Section 80CCF, a deduction up to Rs. 20,000 is allowed on infrastructure bonds.
6. Which bonds provide guaranteed returns — tax-free or tax-saving?
Guaranteed returns are provided by tax-free bonds, where the interest is given by the issuer. On the other hand, tax-saving bonds are based on capital gains exemption.
7. What are the risks involved in investing in tax-free bonds?
In the case of tax-free bonds, there are primarily interest rate risks. In a rarer case, there also might be a credit risk due to due decline in the issuer's credit. This can happen although tax-free bonds are backed by government-related entities.
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