Most people use the words tax free bonds and tax saving bonds, interchangeably. In reality they are quite different. So why does the Government offer tax benefits on bonds? Well, money is needed for long gestation infrastructure projects of top institutions like PFC and REC. If an investor gets tax benefits by investing in tax-free bonds, he will do so. The projects get the money which leads to better products and growth in the economy.
What are tax free bonds? Well, these are bonds where the income received through interest is completely tax-free in the hands of the investors. These bonds are issued by Government backed entities. (This means they have Government Backing). These bonds have zero default risk or very low credit risk. The tax free bonds have long gestation periods in the range of 10-20 years. So, you must invest in tax-free bonds only if you have the capacity to stay invested for the long term.
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The most popular tax free bonds are the municipal bonds. They offer fixed interest and are a low-risk investment. This instrument offers an absolute tax exemption under Section 10 of the Income Tax Act. The money is used to boost infrastructure in the economy.
See Also: How to Get Tax Free Income?
People who seek steady fixed income like senior citizens look at tax-free bonds. They are of long tenure with low default risk. These are an excellent investment for investors in the higher tax brackets like HNIs and film stars who prefer investing in such bonds.
See Also: How to Buy Bonds in India?
Tax saving bonds offer tax benefits on the amount you have invested. The interest earned is fully taxable in investor’s hands.
There used to be a tax section which provided an additional tax benefit of Rs 20,000 a year as tax exemption for investments in infrastructure bonds under Section 80CCF. If you were in the peak tax rate of 31.2%, then an investment of Rs 20,000 in infrastructure bonds under Section 80CCF would mean a tax rebate of Rs 6,240. So effectively, you have invested only (20,000 – 6,240) which is Rs 13,760. This increases effective yield. Do note that these bonds were discontinued from AY 2012-2013.
See Also: Tax Saving Infrastructure Bonds
If your capital gains are totally invested in Section 54EC bonds (These are NHAI and REC bonds), then the entire capital gains are tax-free. You have to make the investment within 6 months of earning capital gains. Any breach of the lock-in of 3 years means you lose the capital gains tax exemption.
Conclusion: While tax-free bonds give you tax-free interest, the tax-saving bonds give special exemptions on the investment you have made.
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