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What are Tax Exempt or Tax Free Bonds issued in India? Who should invest in it and Why?

Tax Free or Tax Exempt Bonds are very attractive investment option for Individuals falling in highest tax bracket. Interest earned on these tax free bonds are fully exempt under section 10(15)(iv)(h) and hence not included in total taxable income. However, investment in Tax Free Bonds does not qualify for deduction under section 80C. So to put it more clearly we can say Tax Free Bonds are a secure way of parking your surplus funds to earn a tax free income, which otherwise many people keep in Fixed Deposits with banks.

Who should invest in Tax Free Bonds?

Tax Free Bonds are good investment option for people who are in 20% and 30% tax bracket. When we invest surplus funds in Fixed Deposit, interest earned on the same is subject to Income Tax liability. However, interest earned from Tax Free Bonds is fully exempt. 

To understand more clearly, lets try with an example-for a person falling in 30% tax bracket, if  FD earns annual interest of 8%, net return available after tax will be 5.6% only i.e. 8%-2.4% (income tax payment of 2.4% i.e. 30% of 8%)). However, if Tax Free Bonds earn 8% return, there will not be any tax liability and effective rate of return will be 8% only. 

 Benefits of Tax Free Bonds:

  • Interest earned on Tax Free Bonds is exempt. There is no tax on interest earned.
  • Interest rates are fixed for the entire Bond period. 
  • Tax Free Bonds are issued by Public Sectior Undertakings only and are generally considered to be safe investment. However, this is advisable to check the Credit Rating of the Company before investing in a particular Tax Free Bond.
  • In some cases additional interest is paid to retail investors. Here Retail investors are those individuals who subscribe for less than Rs. 10 Lacs in Tax Free Bond of particular issue. However, this benefit is in few cases. Many Undertakings do not pay additional interest to retail investors.
  • In case interest rates come down, there will be capital appreciation on sale of these bonds as new instruments will earn less interest.
  • Tax Free Bonds can be sold through Stock Exchanges i.e. NSE/BSE.

 Risk associated with Tax Free Bonds:

  • Though Tax Free Bonds are issued by PSUs there is no counter guarantee by Government for repayment of these bonds / interest thereon. Risk of default in payment of interest and principle cannot be fully ruled out. However, if invested in best rated companies, risk is very low.
  • In case interest rates go up, the value of these bonds will come down in stock exchanges. However, for people with plans to hold these bonds till maturity or for a longer period, this issue should not bother.
  • Tax Free Bonds in general are for a longer duration of 10-20 years, so funds are blocked for a longer term. 

How to Invest in Tax Free Bonds?

Tax Free Bonds can be subscribed at the time of initial offering by the PSU. Later-on these bonds can be purchased through Stock Exchanges. For purchasing through stock exchange you need to have an account with any Stock Broker.

TDS Master Recommendation 

Tax Free Bonds are very good investment option for those falling under maximum tax bracket of 30%. Tax Free Bonds will yield much better return on post tax basis (7.5-8.5%) when compared to Fixed Deposit (5-6%).

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