What are tax-free and tax-saving bonds How can they help you save taxes

What are tax-free and tax-saving bonds? How can they help you save taxes?

 

Bonds are a part of fixed-income securities. They provide stable and consistent returns over the investment period and hedge the risk of investing in equity instruments. However, this is not all. A few bonds, such as tax-free bonds and tax-saving bonds, also help you to save the outgoing on tax liabilities. How? Let’s find out.

What are tax-free bonds?

Tax-free bonds are issued by the central or state governments to raise funds for particular projects. Tax-free bonds provide tax-free returns. One example of these bonds is the municipal bonds that municipal corporations issue. You can invest up to Rs. 5 lakhs under this bond category for a fixed period of 10, 15, and 20 years.

 

The expected return you can expect by investing in tax-free bonds is around 7.3% to 7.5%. The return also depends on the rating of bonds. The interest rate is fixed, and the interest income you earn on tax-free bonds is exempted under section 10 of the Income Tax Act. There is no TDS, either.

 

Let’s take an example. If you invest Rs. 1,00,000 today in a tax-free bond at a coupon rate of 7.3% for a lock-in period of 10 years, at maturity, you will receive Rs. 202,300. The interest income is Rs. 1,02,300, which is entirely tax-free. Not a bad deal, is it? However, if you sell these bonds in the secondary market, if they are listed, you will have to pay tax on capital gains.

 

Because the government backs these bonds, insolvency is never a concern. The funds collected via tax-free bonds are usually invested in infrastructure and housing projects.

What are tax-saving bonds?  

If you want to reduce your tax liability, investing in tax-saving bonds can be a good option. Under section 80CCF, you can invest Rs. 20,000 per year by investing in these bonds above Rs. 1.5 lakh exemption under section 80C. This deduction can be added with other deductions to lower the tax liability. (The same tax implication applies to government-issued infrastructure bonds.)

 

Tax-saving bonds issued by the government offer interest of 7.75%-8% and have a typical lock-in period of 5 years. There are often clauses of buyback after the initial 5 years. The interest income you receive by investing in this bond is taxable.

 

If you are wondering why you should invest in tax-saving bonds instead of tax-saving FDs, the answer is higher returns. The return you can expect by investing in a tax-saving bond is 7.75-8%, while the same for tax-saving FD ranges from 5.50% to 7.75%.

 

Also, a tax-saving FD has a fixed term of 5 years and offers tax exemption of up to Rs. 1.5 lakh under Section 80C. On the contrary, tax-saving bonds offer an additional exemption of Rs. 20,000 beyond Section 80C. So, all in all, the benefits you can receive from these bonds outweigh the benefits of tax-saving FDs.

Conclusion

 

Both tax-fee and tax-saving bonds are good investment options. The first provides tax-free returns, and the latter allows tax exemptions. Based on your requirements, you can decide to include them in your investment portfolio.