Salients features of tax free bonds and points to be noted while investing in tax free bonds
The salient features of the tax-free bonds:
What are tax-free bonds: These bonds are mostly issued by government enterprises and pay a
fixed coupon rate (interest rate). As the proceeds from the bonds are invested
in infrastructure projects, they have a long-term maturity of typically 10, 15
or 20 years.
Tax benefits:
The income by way of interest on tax-free bonds is fully exempted from income
tax. The interest earned from these bonds does not form part of your total
income. There is no deduction of tax at source (TDS) from the interest, which accrues
to the bondholders.
But remember that no tax deduction will be available for the
invested amount.
Interest rate:
The coupon (interest) rates of tax-free bonds are linked to the prevailing
rates of government securities. So these bonds become attractive when the
interest rates in the financial system are high.
Interest payment: The interest on these bonds is paid annually and
credited directly in the bank account of the investor. Tax free bonds vs bank
fixed deposits (FDs): The interest earned on bank FDs and other normal bonds
are added to the income of the investor and taxed as per the income-tax slabs.
As interest earned from tax-free bonds are not taxed, investors in higher tax
brackets mostly earn a better post-tax return than from FDs.
But remember, the bank FDs score over tax-free bonds in terms of
liquidity as these bonds have longer maturity tenure.
Credit risk: Since tax-free bonds are mostly issued by
government-backed companies, the credit risk or risk of non-repayment is very
low.
Liquidity: The tax-free bonds get listed and then traded
on the stock exchange(s) to offer an exit route to investors.
But these bonds might not enjoy high liquidity as they are
long-term in nature. Do you need a demat account? The bonds could be issued
both in demat and physical mode.
Secondary market: Investors can buy and sell these tax free bonds on the stock
exchanges.
Though the interest earned on these bonds is tax-free, any capital
gain from sale in the secondary market is taxable. Short-term capital gains
from sale of tax-free bonds on exchanges are taxed at the normal rate, while
long-term capital gains are taxed at 10% without indexation and 20% with
indexation, whichever is lower. By indexing, you adjust the purchasing price
with annual inflation.
