Tax Free Bonds

As the name suggests, tax-free bonds are free from taxes since these allow the government to generate interest income. These come with a fixed rate of interest and the profit made from them are generally invested in infrastructure related projects.

What are Tax-free Bonds?

Tax-free bonds have acquired a lot of popularity these days considering that the interest income earned from these bonds are free from being taxed. These bonds are issued by government enterprises and there is hardly risk of non-payment of interest amount. The tax-free bonds provide fixed rates of interest. The profits from these bonds usually get invested in infrastructure projects.

Tax-free bonds come with a long-term maturity period of 10, 15, and 20 years. The major issuers of tax-free bonds in India are Power Finance Corporation, Indian Railway Finance Corporation and NHAI to name a few.

What are benefits of Investing in Tax-free Bonds?

Tax-free bonds come with a lot of attractive benefits. Listed below are the major benefits offered by tax-free bonds:

  • Investors can enjoy tax benefits by investing in tax-free bonds. These bonds are 100% tax-free. The interest income received from these bonds is calculated as a part of your total annual income.
  • You get higher interest rates on your invested amount. Tax-free bonds provide good returns on your investments.
  • Interest is paid on these bonds annually. It gets directly credited in the bank account of the investor.
  • Tax-free bonds provide steady returns for longer terms such as 10 and 20 years.

How are tax-free bonds and tax-saving bonds different?

There are a few differences between tax-free bonds and tax saving bonds. The major differences between tax-free bonds and tax savings bonds are:

Tax-free Bonds Tax-Saving Bonds
1) In tax-free bonds, the interest income earned from investing in them are free from taxation as per the Section 10 of the Indian Income Tax Act, 1961. 1) But the tax saving bonds don't offer this benefit. In a tax saving bond, only the initial investment is free from tax.
2) Tax-free bonds offer slightly higher rates of interest. 2) When compared to tax-free bonds, tax-saving bonds offer lower interest rates.
3) Any retail investors can invest in tax-free bonds worth up to Rs.5 lakhs. 3) The investing criteria is limited in the case of tax-saving bonds.
4) Tax-free bonds which are absolutely free and do not have any caps in terms of investment. 4) Tax savings bonds are investment instruments for individual investors who get tax exemption on investing a maximum amount of Rs. 20,000 under Section 80CCF of the Indian Income Tax Act.
5) Tax-free bonds come with a lock-in period. 5) Tax-saving bonds offer you a buyback clause at the end of each 5 or 7 years which enables you to withdraw your investments.

Things to Remember before Opting for Tax-free Bonds

Wisely chosen bonds can act as safe haven for your investments. In this case, tax-free bonds can serve as an ideal investment tool as they are totally free from tax payment. However, before investing in tax-free bonds you need to know the basic facts about tax-free bonds and how they function:

  • Tax-free bonds come with a lock in-period of 10 to 20 years. The amount invested in a tax-free bond cannot be withdrawn before the expiry of applicable lock-in period.
  • The interest income earned from these bonds are completely free from income tax.
  • Tax-free bonds can be transacted in stock exchanges. Any investor can buy and sell these tax-free bonds on the stock exchanges.
  • Although the interest earned by investing tax-free bonds is not taxable, any capital gains received from selling these tax-free bonds in the secondary market are taxable.
  • Tax-free bonds are issued both in demat format and physical mode.
  • Credit risk or the risk of non-payment is very low in tax-free bonds as these bonds are mostly issued by the government enterprises.
  • Interest rates on tax-free bonds ranges between 7.3% to 7.5% per year. However, these rates are dependent on the ratings on bonds given by credit rating agencies.

How to Invest in Tax-free Bonds?

Investors can buy these tax-free bonds either in physical format or demat form. The subscription period for investing in tax-free bonds is open for a limited period of time within which you need to buy these bonds. An investor needs to furnish his/her Permanent Account Number (PAN), if the bonds are purchased in the physical format.

Who can Invest in Tax-free Bonds?

The following categories of investors can invest in tax-free bonds:

  • Qualified Institutional Buyers who have been defined under the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000.
  • Limited liability partnerships, partnership firms, trusts, co-operative banks, regional rural banks, corporates and other authorized entities.
  • Retail individual investors who include members of Hindu Undivided Family and Non-Resident Indians.
  • High net-worth individuals which include those investors whose risk appetite are low and can invest up to Rs.10 lakhs.

Thus, the tax-free bonds are ideal for modest risk appetite investors as well as high net-worth individuals who are looking for a steady source of annual income, and for those who can afford to lock-in their capital for longer tenures.

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