In a bid to regularise the economy and account for all the actual income being generated, the government has made sure that all investments and savings beyond a particular limit are taxed. And while there are tax exemptions to most investments, there is a limit which does not always satisfy the investment appetite for many. If you are not solely looking at wealth creation but tax-saving investment options, tax-free bonds are a great option. Although they may not be completely tax free always, they have significant advantages when it comes to paying tax as any interest earned from tax-free bonds is exempt from tax.
The tenure of these bonds is usually 10/15 or even 20 years. They are also listed on stock exchanges to offer an exit route to investors. The bonds are secured, redeemable and non-convertible in nature.
The interest that an issuer can offer to investors depends on the yield of government securities prevailing around the time of issuance. Once set and offered, it will remain fixed for the entire tenure. The interest rate will depend on two factors – One, on the ratings of the issuer and secondly, whether the investor is a retail or a high net worth investor.
Ideal For Large Investment
Tax-free bonds are ideal for large investment amount and thus are hugely popular with high net worth investors (HNIs) because they allow parking a huge lump sum at one place. They are perceived to be relatively safe as they are primarily 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.
The interest income earned is exempt from tax under Section 10 (15) (iv) (h) of the Income Tax Act, 1961. However, there will be no tax benefit on the amount of investment made in such bonds. There is also no applicability of TDS on interest income.
The benefit here is that unlike fixed deposits, NSCs and other bonds, the interest earned from these bonds is tax free. Assuming a tax-free coupon yield of 8.2%, the implied pre-tax rate will be to the tune of 11.79% for investors in the 30% tax bracket (those with more than Rs 10 lakh taxable income a year).
Not Suitable for Wealth Creation
Most of our investments or tax savings are aimed at wealth creation. Tax-free bonds, however, are not recommended to create wealth in order to meet long-term goals such as child education, marriage or retirement. They primarily help one to keep one’s tax liability at bay, and thus are suited when you either get a lump sum amount that you want to park, or recurring high income amounts that will help you save tax.
Capital Gains Are Taxable
If there is any capital gain on transferring them on exchanges, that will be taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges are taxed as per the tax rate of the investor. If bonds are held for more than 12 months, the gains are taxed at 10.3 per cent. There will not be any benefit of indexation in them.
While short-term capital gains from such a sale will be taxed as normal income, long-term capital gains will be taxed at 10%. The bonds must be held for at least 12 months for the profits to be treated as long-term gains. Unfortunately for investors, the long-term capital gains from these bonds are not eligible for indexation benefit which could have cut tax.
Not For Short-Term Investors
The tenure of tax-free bonds being long term, one should carefully invest in them keeping intermittent goals in mind. Invest in them only if you are sure not to use the funds for such a long period. Liquidity is low in tax-free bonds. Usually, they are listed on stock exchanges to provide an exit route to investors. Price and volume may play a spoilsport while off-loading them. Further, frequency of interest payment in tax-free bonds is generally annual.
Remember that tax-free bonds are mostly government bonds. So, do not expect quick returns or short-term withdrawals. Also consult your accountant before making any big-ticket investments in these bonds.
(The writer is CEO at Bankbazaar.com)