Tax-Free Bonds Vs. Tax-Saving Bonds: Which One Should Be Your Pick?

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Grip Invest
Grip Invest
Published on
Apr 02, 2024
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    Tax-Free-Vs.-Tax-Saving-Bonds

    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.

    Tax-Free Bonds Vs. Tax-Saving Bonds

    Basis

    Tax-Free Bonds

    Tax-Saving Bonds

    Applicable section of Income Tax Act

    Section 10(15)

    Section 80CCF 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

    Section 80CCF provides exemptions up to INR 20,000, and Section 54EC provides exemptions subject to the investment amount and the capital gain

    Conclusion

    While tax-saving bonds give investors tax benefits on the investment amount, tax-free bonds make the interest exempt. Investors must consider factors like investment goals, risk appetite, tax implications, and maturity periods before deciding on a suitable investment. 

    Explore Grip Invest and stay updated on all relevant financial planning opportunities.

    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.


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