Tax-free bonds: Bond to the rescue

Written by Adhil Shetty | AdhilShetty | Updated: Jan 25 2014, 02:45am hrs
Tax benefitsTax-free bonds have become a popular tool in the investment circle and steadily gained popularity among long-term investors due to tax benefits.
Tax-free bonds have become a popular tool in the investment circle and steadily gained popularity among long-term investors due to tax benefits. Unlike fixed deposits, the interest earned from NSCs and other bonds are tax free. They offer a good investment opportunity, especially to those who come under higher tax brackets of 20% and above. The other advantages are that they offer tremendous scope for capital appreciation and that one can buy and sell them easily via stock exchanges.

Tax-free bonds issued by the companies usually come with an annual interest payment option. This may not sound extremely pleasing if you wish to receive a monthly income from the investment. However, a few smart steps will help you generate a monthly income from your investment.

Capital gains tax

Under the provisions of Section 2 (29A) of the I-T Act, listed bonds are treated akin to long-term capital asset if they are held for more than 12 months. However, for periods less than 12 months, the bonds are treated as short-term capital, and gains are taxed as per rates in the I-T Act. Additionally, the 2% education cess and the 1% secondary and higher education cess are also applicable while clubbing the gains to the total annual income.

How it works

The first step is to purchase tax-free bonds issued by government-backed firms like HUDCO, PFC and IRFC and stay invested for at least one year. From the 13th month onward, you can start selling bonds worth 1% of your investment per month.

For example, if you come under the 30% tax bracket and have purchased tax-free bonds worth R10 lakh from HUDCO with an investment period of 10 years. Selling bonds worth 1% of your investment every month will give R10,000 every month for eight years and four months.

The monthly amount is available against an investment of R10 lakh for 100 months after the one year, thus helping you avoid the short-term capital gains tax. Thus you stand to gain from the annual tax savings while getting a monthly income at a decent interest rate.

Basic arrangements

For this scheme to work, certain arrangements have to be made and process followed.

* You need to purchase the bonds via a demat account to enable you to sell a fixed proportion of bonds every month.

* The value of the tax-free bonds should increase exactly equal to the monthly value of their annual interest after each annual interest payment.

* Tax is paid every month after the income from the sale is received.

* Brokerage charges are not considered as they vary from one investor to other and across brokering houses.

Investment tenure

Variations caused by increased investment tenures can be adjusted either by cutting down the percentage of the sale of bonds or doubling investment. So you need to purchase bonds worth at least R1.5 lakh to R2 lakh if you have to sell 1% of the bond and receive R1,000 as monthly income for 15 to 20 years.

Annual interest

Further, you will get your annual interest, which can be utilised for further investments or for any financial need that you are unable to meet with your monthly income from the sale of tax-free bonds. The interest thus serves as a bonus.

Primary objective

The idea is to generate a fixed monthly income while keeping investments as tax efficient as possible. This is why you need to start selling soon after completing the one-year period. You will have to pay only 10% tax on long-term capital gains that you make by selling them.

This method of investment in tax-free bonds is also a suitable option for senior citizens looking for a fixed monthly income by investing their pension amount in government-backed investment initiatives.

It is definitely a better option than investing in mutual funds, fixed deposits and other taxed bonds, especially for those who fall under a higher tax bracket. With the government recently allowing 13 institutions to raise more than R48,000 crore by issuing tax-free bonds, and with several companies awaiting Sebis nod for such issues for infrastructure development, tax-free bonds are bound to move up the chart as one of the most favoured options for investors.

The writer is CEO,