 Tax- Free Bonds Vs. Tax–Saving Bonds- What Should You Choose?

Every year, as the days of tax filing draw near, we look for tax-saving investment opportunities. The two most talked about terms are tax-free bonds and tax-saving bonds. According to the Income Tax Act 1961, these terms have different features and rules for tax benefits.

Now, let us understand how these differences can help reduce the tax burden.

What are the Factors to Consider Before Investing in Bonds?

When investing in bonds, it’s important to consider factors that align with your financial goals, risk tolerance, and investment timeframes. These factors can ensure that your investment is in line with your financial objectives.

Key considerations include:

Creditworthiness: Check the bond issuer’s credit rating from independent rating agencies like CRISIL or ICRA. These ratings reflect the issuer’s ability to pay principal and interest on time, aiding in informed investment decisions.

Interest Rate Risk: Be aware of how changes in interest rates affect bond prices. Rising rates decrease the value of existing bonds with lower rates, while new bonds become more attractive. Consider your investment horizon and how interest rate fluctuations might impact on your bonds.

Inflation Risk: Inflation can erode the real return on bonds over time. High inflation reduces the purchasing power of future coupon payments and principal repayment. Long-term bonds are more susceptible to inflation risk, so consider Treasury Inflation-Protected Securities (TIPS) for inflation protection.

Liquidity is a key factor to assess when considering a bond investment. It determines how easily a bond can be bought or sold without significantly affecting its price. Bonds from smaller issuers or with longer maturities may be less liquid, leading to wider bid-ask spreads, lower marketability, and higher transaction costs.

Tax-Free Bonds vs. Taxable Bonds

Tax-Free Bonds:

Tax-free bonds are typically issued by government-backed entities such as public sector undertakings and infrastructure companies (e.g., NHAI, NTPC, HUDCO, REC, REL, IREDA, PFC, IRFC, NABARD), offering very low default risk due to government support. These long-term investments have maturities of 10, 15, or 20 years. The interest income is entirely tax-free under Section 10(15) of the Income Tax Act, with no TDS on the interest. There is no upper limit on investment, making them attractive to High Net-Worth Individuals (HNIs) and institutions. These bonds can be held in either physical form or demat form.

Pros:

Issuer: Typically issued by government-backed entities such as public sector undertakings and infrastructure companies.

Risk: Very low default risk due to government backing.

Tenure: Long-term investments with 10 to 20-year maturities

Tax Benefits: Interest income is entirely tax-free under Section 10(15) of the Income Tax Act. No TDS on interest income.

Investment Limits: There is no upper limit on investment, making them attractive to High-Net-Worth Individuals (HNIs) and institutions.

Forms: Can be held in physical form or demat form.

Cons:

Reduced Liquidity: Tax-free bonds are less liquid than equities or mutual funds. Selling them before maturity means relatively lower returns.

Capped Earnings: The consumer can lose out on higher earnings if the interest rates rise. Also, rising inflation can erode the real value of the bond income, reducing the purchasing power.

Economics Comparison:

Criteria	Tax Free Bond	Taxable Bond
Face Value	₹100,000	₹100,000
Annual Coupon	6.5%	8%
Annual Interest	₹6,500	₹8,000
Post-Tax Yield	6.50%	5.504%
Tax Bracket		31.2%
Tax Paid		₹2,496
Post Tax Interest		₹5,504

Conclusion: Tax-free bonds could yield a higher post-tax return compared to taxable bonds despite a lower coupon rate. Taxable high yield bonds could offer higher post tax returns compared to tax-free bonds but carry higher investment risk.

Tax-Saving Bonds:

While tax-free bonds provide tax exemption on interest income, tax-saving bonds offer flexibility in managing tax benefits. Specifically, the invested amount in tax-saving bonds (up to a limit) is deducted from taxable income, thereby reducing the individual’s overall tax liability. Tax-saving bonds fall under specific categories outlined in the Income Tax Act of 1961.

Types of Tax-Saving Bonds:

Tax-Saving Bonds Under Section 80CCF:

Benefit: Additional deduction of ₹20,000 for investments in infrastructure bonds.

Eligibility: Only resident individuals.

Example: For a taxpayer in the 31.2% tax bracket, investing ₹20,000 yields a tax rebate of ₹6,240, effectively reducing the investment cost and enhancing the yield.

Note: These bonds were discontinued from AY 2012-13.

Capital Gains Exemption Bonds Under Section 54EC:

Benefit: Allows reinvestment of long-term capital gains (other than from shares and securities) in specified bonds to make the gains tax-free.

Issuers: NHAI, IRFC, REC, PFC.

Conditions:

Investment within 6 months of the capital gain.

5-year lock-in period.

Maximum investment limit of ₹50 lakhs per assessment year.

Here are the key differences between tax free and tax saving bonds:

Factors	Tax Free Bonds	Tax Saving Bonds
Investment Tenure	Long term (10-15 years)	Medium term (usually 5 – 10 years)
Tax Benefits	Interest earned is tax free	Investments are tax-deductible, up to Rs.1.50 lakh under Section 80C of the Income Tax Act
Returns	Guaranteed Returns	Fixed Returns
Maturity Period	Fixed maturity period	May or may not have a fixed maturity period
Liquidity	May have lower liquidity	Usually have higher liquidity
Interest Rates	Interest rates are typically lower	Interest rates may be higher

Pros of RBI Tax Savings Bond

Safety: Backed by the Indian government, offering risk-free investment.

Assured Returns: Fixed interest rates provide predictable returns.

Tax Benefits: Eligible for tax deductions under Section 80C of the Income Tax Act.

Liquidity: Better liquidity than some tax-saving investments like PPF or NSC, with premature redemption allowed under certain conditions.

Cons of RBI Tax Savings Bond

Lower Returns: Typically offer lower interest rates than long term investments in equities or mutual funds, potentially failing to keep pace with inflation.

Lock-in Period: Investments are tied up for a specified duration, with limited premature withdrawal options.

Interest Taxation: Interest earned is taxable, reducing adequate returns for those in higher tax brackets.

Fixed Returns: Fixed interest rates mean no benefit from potential rate increases during the bond’s tenure.

Limited Flexibility: Limited options to make changes or switch investments once committed.

How to Buy Tax-Free Bonds

Online Platforms:

Complete KYC online.

Browse and select tax-free bonds.

Click “Buy this Bond” and submit details for assistance from bond managers.

Secondary Market: Purchase through the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE) via a demat account.

Summary

Tax-Free Bonds: Best for long-term investors seeking tax-free interest income with government-backed security. Suitable for those in higher tax brackets due to the tax exemption on interest.

Tax-Saving Bonds: Ideal for reducing taxable income through investments, though interest is fully taxable. Suitable for individuals seeking tax deductions on the investment amount, especially for reinvesting capital gains.

FAQs

Who Issues Tax-Free Bonds?

Tax-free bonds are issued by public sector companies such as NHAI, NTPC, HUDCO, REC, REL, IREDA, PFC, IRFC, and NABARD.

What is the Tenure of Tax-Free Bonds?

These bonds are long-term investments with typical maturities of 10, 15, or 20 years. You will receive the original investment amount upon maturity, while the interest is transferred periodically (quarterly, semi-annually or annually) to your bank account.

 What is the Tax Impact on Tax-Free Bonds?

Interest income from these bonds is tax-exempt, meaning no tax deducted at source (TDS) applies.

How Do I Buy Tax-Free Bonds?

When issued by the company, these bonds can be purchased through the primary market. However, they are not currently available in the primary market, so you can buy them through the secondary market on the Bombay Stock Exchange (BSE) or the National Stock Exchange (NSE).

Tax-Free Bonds vs. Tax-Saving Bonds: Which is Better? Tax-free bonds benefit individuals in high tax brackets as the interest is tax-exempt. Tax-saving bonds can reduce taxable income as they offer deductions on the investment amount. Your choice depends on your income level, investment horizon, and financial goals.

How Do I Get Tax-Exempt Bonds?

Use your online broker’s website to order bonds and place the order through a trading account.

Transfer funds for the investment amount.

Are Tax-Exempt Bonds Taxed at Maturity?

No, the interest income from tax-free bonds is exempt under Section 10(15). However, capital gains may be taxable if the bonds are sold or redeemed before maturity, depending on the holding period and applicable tax slab.

What is the Maturity of Tax-Saving Bonds? Tax-saving bonds typically have a medium-term maturity of 5 to 10 years, with a lock-in period usually of 5 years from the date of issuance.

How Do I Purchase Tax-Free Bonds?

Complete your KYC online

Browse and select Tax-Free Bonds from the explore page.

Choose your preferred Tax-Free Bonds from the curated list.

Click “Read More” for detailed issue reports and to calculate your investment against the final payout.

Click “Buy this Bond” and submit your details. The Bond Managers will assist you with the rest.