Choosing between tax-saving and tax-free bonds



The market has been flooded with a spate of bond issues in recent times. Several companies such as IDFC, L&T infra, IFCI, REC, PTC Financial Services, HUDCO, IRFC, NHAI have lured us into parking our money with them by offering attractive interest rates.

Although the ‘tax benefit' aspect of these issues has been the scoring point, did you know that all these offers do not carry the same benefit? While the ‘tax-free' nature of the bonds was the highlight of those like HUDCO or NHAI or IRFC , the other issuers concentrated on the ‘tax-savings' that their bonds would enable.

Yes, in both cases post-tax yields are much superior compared to most other debt instruments.

But there stops the similarity between them.

INITIAL INVESTMENT

A ‘tax-saving' bond is one in which the initial investment is exempt from tax.

Similar to the deduction you get from your total income for your PPF investments or for paying your daughter's school fees under Section 80C of the Income-Tax Act, the investment in such bonds will be allowed as a deduction under Section 80CCF. This debt instrument typically targets those who exhaust the Rs 1 lakh savings limit under Section 80C but still have taxes to pay.

INTEREST INCOME

On the other hand, for ‘tax-free' bonds, the deduction on initial investment is not available. ‘Tax-free' simply means that the interest income you earn from the investment in these bonds is free from being taxed. The tax-saving bonds don't enjoy this benefit. Hence, like how you may be paying taxes on the interest on your fixed deposit investments, interest income here will be subject to tax.

That said, the interest and hence the tax outgo on the interest might not be substantial.

This is because Section 80CCF allows only a maximum of Rs 20,000 to be invested in these bonds.

In comparison, in the tax-free bonds, retail investors like you and I could invest up to Rs 5 lakh. These bonds typically offer slightly higher interest rates to retail investors as well.

Again, considering the Rs 20,000 restriction, tax-saving bonds would not be of great help in parking your surplus funds or in bringing in a meaningful stream of regular cash flows in the form of interest income.

But the tax-free bonds would serve both purposes. Retired individuals looking to invest a lumpsum and earn a fixed income annually from the corpus can lock into this.

Given the high ceiling on the investible amount, tax-free bonds would also be ideal for HNIs (High Net worth Individuals). These issues have a 30 per cent reservation for HNIs.

BUY-BACK PLAN

However, while tax-free bonds require you to keep your money invested for 10/15 years, tax-saving bonds offer a buyback clause at the end of five/seven years.

The advantage of opting for a buy-back plan is that you can exit if at the end of five years, you find that the interest rates on alternative investment options are better.

But even if tax-free bonds require a longer-commitment period, it is worth locking into, especially in a year like this in which interest rates are at their peak.

Also, it is not that these instruments are illiquid.

Tax-free bonds can be traded in the stock exchange.

If you choose to sell in the market, you will incur capital gains tax – if sold within one year, short-term capital gains tax at the normal slab rates; if not, at ten per cent without indexing the cost (long-term capital gains tax).

Tax-saving bonds too would be listed albeit, at the end of a lock-in period of five years. So besides opting for the buyback, you can exit through this route also.

However, capital gains tax will be applicable.

Remember that any exit in both cases will be exposed to interest rate movements which can depress or shoot up bond prices.

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