Tax-free bonds are becoming popular nowadays as the interest income earned is free from being taxed. Read on to know more.
If you ever seek suggestions for a dream investment instrument, a majority of investors across the financial spectrum would vouch for one that offers secured returns and a tax-free component. It is, therefore, no surprise that Tax-Free Bonds have emerged as one of the popular investment options especially for the taxpayers in the higher brackets to offset their tax outgo and embrace an opportunity to earn income from investment.
What Are Tax-Free Bonds
Tax-free bonds just like other bonds are primarily debt security financial instruments. These bonds require the approval of the central government before issuance and hence are usually offered by government enterprises thereby reducing any risk of non-payment of interest amount. Tax-free bonds offer a fixed interest rate and have a long-term maturity period ranging from 10, 15 to even 20 years and proceeds from such bonds are invested in various infrastructure projects.
The one big benefit of investing in these bonds is the tax-free aspect of interest. So any income that you may earn by way of interest on investment in such bonds is fully exempted from income tax under Section 10 (15) (iv) (h) of the Income Tax Act, 1961. Similarly, there is no TDS deduction from the interest owing to the tax-free status for interest earned. However, the principal invested amount attracts the TDS applicability for investment in such bonds.
Tax-Free Bonds For Higher Tax Bracket
Even though the interest rates offered by tax-free bonds are slightly lower than normal bonds, they are still an ideal investment option especially for those in the higher tax brackets. Take for example A who is in highest tax paying slab of 30.9% tax. He invests in a bank Fixed Deposit offering 7.5% returns for which effective interest rate earned would only be 5.1825% post-tax. This is slightly lower than what a basic savings bank account offers and a little too low to beat the inflation in the long run.
To offset tax obligation, A needs to choose an instrument with a tax yield of 8.68% to come close to the 6% interest rate offered by most tax-free bonds. In the current low-interest rate scenario, there are not many financial instruments offering such interest rates. So opting for tax-free bonds remains an optimum option.
Things To Know Before Investing In Tax-Free Bonds
Unlike other investment options, you cannot invest in tax-free bonds throughout the year. The investment window is open only for a limited tenure within which you need to buy these bonds. The tenure for tax-free bonds are long between 10 to 20 years and offers limited liquidity with no withdrawal before the lock-in period.
You can, however, trade tax-free bonds on a stock exchange through a valid demat account. Any capital gain on transferring such bonds attracts tax. For a holding period below 12 months you are levied a capital gains tax as per the individual tax rate and for bonds held more than one year, a tax rate of 10.3% without indexation benefits is levied.
There are no tax-free bonds open for subscription currently, but if you are someone with a medium risk appetite or a high net-worth individual looking for a steady source of income with no high liquidity requirements, tax-free bonds are tailor-made to be part of your financial plan.