How Tax-Free Bonds Are Different From Tax Saving Bonds

As the end of the financial year, 2021, is nearer, the taxpayers are looking for tax benefits tax benefit investment options. Taxpayers have many options to choose from. However, two terms for investment are often used interchangeably as tax-saving bonds and tax-free bonds.

These are two different investment options, and also the tax treatment for investment in these bonds varies. 

Let us understand the key features and varying tax treatment of the tax-free bonds and tax-saving bonds:

Tax-Free Bonds

Government-backed entities issue these bonds, and hence they carry zero risks. These bonds are generally available for a long-term period, i.e. basically up to 10, 15 or 20 years. They are called tax-free bonds because interest income received from such bonds is entirely exempt from tax.

The interest is exempt under section 10 of the Income Tax Act. However, the deduction is not available on the principal amount of investment in the bonds. Since the interest received from the tax-free bonds are exempt, tax is not deducted at the source on receipt of interest payments. These bonds are available in both physical form and Demat form.

One cannot redeem these bonds before maturity, but they can be sold before their secondary market maturity. However, if the bonds are sold before maturity, they will attract capital gains. The investment in these bonds is best suitable for risk-averse investors with high net worth. The effective post-tax yield is higher than the yield of taxable bonds or bank fixed deposits for the highest tax bracket individuals. 

Let us take an example of the tax-free bonds and taxable bonds if the taxpayer falls in the highest tax bracket:

Bond Particulars Taxable Bond or FD Tax-Free Bond
Date of Bond issue 1st Jan 2020 1st Jan 2020
Face value of the bond 1,00,000 1,00,000
Annual coupon rate 8% 6.5%
Annual interest payable 8,000 6,500
Tax Bracket 30% + 4% cess Nil
Tax Paid 2496 Nil
Post tax interest 5,504 6,500
Post tax yield 5.504% 6.5%

As per the above example, the coupon rate of tax-free bonds is lower than that of taxable bonds. But when the impact of tax at 31.2% is considered at the peak rate, the tax-free bond earns nearly 100 basis points more in post-tax terms. That is what makes tax-free bonds more attractive for high net worth investors.

Tax-Saving Bonds

Infrastructure bonds are the popular tax-saving bonds that are also called 54EC bonds. The bonds are mid-long-term bonds with a minimum tenor of 5 years. Investment in these bonds offers tax exemption on long-term capital gains from assets other than shares and securities.

However, there will be a lock-in period of five years on these investments. One should invest in such bonds within six months of the capital gain transaction. These bonds are not listed on the stock exchange. Hence, one has to directly purchase it from the issuer in physical form or Demat form. Since these bonds are not available in the secondary market, the investor cannot redeem or sell them before maturity. 

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