Explained: Why tax-free bonds suit those in the highest tax slab

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Published: February 19, 2020 4:00:50 AM

Returns on tax-free bonds are not only higher than those on bank FDs, they also do not attract any taxes. Investors can lock in the current interest rate and do not have to worry about reinvestment risk or tax changes

While the interest payments on these bonds are free of tax, there would be capital gains tax if an investor sells before maturity at a profit. While the interest payments on these bonds are free of tax, there would be capital gains tax if an investor sells before maturity at a profit.

At a time when banks are lowering their term deposit rates and the Union Budget presented on February 1 proposing that dividends will be taxed in the hands of the investor at his marginal rate, many investors are now considering investing in tax-free bonds to earn higher returns and save taxes, too.

While the Budget proposal will benefit investors in low tax brackets, there will be additional outgo for higher tax bracket investors. Moreover, TDS will be deducted at 10% for dividends above Rs 5,000 in a year.

Tax-free bonds to be attractive
Experts say tax-free bonds of public sector companies such as IRFC, PFC, NHAI, HUDCO, REC, NTPC, NHPC will become popular with investors in higher tax bracket. The tax-free status of these bonds will remain till maturity. Investors can lock-in their capital for a longer tenure and earn tax-efficient returns.

Currently, under tax-free bonds, while the investor does not get any tax exemption under Section 80C of Income Tax Act, the interest accrued is completely tax-free under Section 10(15)(iv)(h). At present retail individual investors can buy tax-free bonds from the secondary market as the government has not issued these bonds in the primary market after 2016.

Even the returns are at least 200 basis points higher in tax-free bonds as compared with term deposit rates of the country’s largest lender State Bank of India.

For instance, while a five to 10-year SBI fixed deposit will give you an interest of 6% per annum, which will translates into a post-tax return of 4.1% for those in the highest tax bracket of 31.2%, tax-free bonds will fetch around 5.7% tax free.

So, tax-free bonds suit those in the highest tax slab. As tax-free bonds have long tenure, typically maturing after 10, 15 or 20 years, it is an ideal investment to build a retirement portfolio. Moreover, investor can lock in the current interest rate and do not have to worry about reinvestment risk or tax changes.

While the interest payments on these bonds are free of tax, there would be capital gains tax if an investor sells before maturity at a profit. While the interest received from tax-free bond is exempt from tax, the investor will have to disclose the amount in the income tax return as exempted income.

Jayant R. Pai, head of products, PPFAS Mutual Fund, says tax-free bonds are a credible alternative. “However, given that this trade has already been ‘discovered’, buyers should exercise caution and not plunge headlong into it,” he says.

Bonds from the market
Tax-free bonds are traded in the stock exchange (BSE and NSE) only through demat accounts usually in Lots of `10 lakh each. Bond holders can sell them to another individual and it is much similar to trading shares in a stock market. However, there is no Call or Put option in most of them and buyers must hold on till maturity (around 2-11 years from now) as liquidity may not always be readily available. One must also look at the credit rating of the issuer and the tenure of the bond. The government invests the money collected from tax-free bonds in infrastructure and housing.

As long-duration bonds reduce re-investment risk, investors should be aware of the tenure and interest rate before buying tax-free bonds. The interest is paid on a yearly basis to the investor’s bank account directly and at maturity he will get back the face value invested.

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