One of my friends,  who had already decided to invest his retirement savings in such a way so that he does not have to pay any tax after his retirement and so wanted to invest in tax free bonds,  had called me to know about the tax-free bonds available. I discussed the matter threadbare with him to understand why he was adamant to invest his retirement funds in tax-free bonds so that he does not have to pay any tax. This article is the result of discussion I had with him.

What are tax-free bonds and how these are priced?

Subject to a few, all the interest income received by you whether from banks or bonds of various companies are taxable in your hands. However interest received on certain bonds issued by Government enterprises and as notified under Section 10 is tax free. These bonds were issued  a few years back to help government enterprises to raise funds but nowadays such bonds are not issued. So your only option to own such bonds is to buy them from the open market. The bonds have an issue price which is generally its face value.  The bondholder gets interest on bonds at the rate specified at the time of issue of the bonds. This rate is called coupon rate and which generally remains the same during its tenure.

Tax Free Bonds

Since the interest rates keep on changing depending on various factors. The bonds though are issued at face value but once these are issued these are not traded at face value. These bonds are either traded at discount or at premium depending on whether the market interest rate is lower or higher than the coupon rate of such bonds. In case of tax-free bonds the market price of such tax-free bonds has inbuilt the fact that interest on such bonds are tax free and therefore such bonds are priced at higher than the taxable bonds.  So the yield on such bonds is lower than other products like fixed deposits or other bonds of same level of safety.

Who should buy  Invest in RBI bonds and who should Invest in Tax free bonds?

Just because interest on such bonds is tax-free in your hands, it does not mean that you should buy them blindly. These bonds are for very long period and are not so frequently traded and therefore are not as liquid as other investments. So in case you need money urgently, you may have to sell them at lower than the price you should get in normal circumstance.

The present yield on AAA rated bonds of government enterprises is around 4.90%-5%%. Against these tax free bonds individual investors have an alternative option to invest in equally secured product i.e. RBI Floating Rate Savings bonds.  The RBI bonds presently offer you interest rate of 7.15% which is floating and is fixed every six months and is benchmarked against interest rate payable on National Saving Certificates. So as and when the interest rate cycle reverses the interest payable on such RBI bonds will also go up.

Looking at the rate of interest offered by the banks on their fixed deposits, the only risk free product available for a layman individual investor is the RBI floating rate savings bonds. However since the interest on these bonds are taxed at the slab rates, post tax net interest in the hands of individual is tabulated for persons in different tax slabs. Though the basic exemption limit still remain Rs. 2.50 lakhs but due to rebate available under Section 87A all the taxpayers with taxable income below 5 lakhs do not have to pay any tax hence people in the income group upto Rs.  5 lakhs have been clubbed under zero tax rate group.

Income Range Rs. Effective tax rate Post tax returns of  7.15% RBI  bonds
2 to 5 lakhs 0% 7.15%
5 lakhs to 10 lakhs 20.80% 5.66%
10 lakhs to 50 lakhs 31.20% 4.92%
50 lakhs to 1 Crore 34.32% 4.70%
1 Crore to 2 Crore 35.88% 4.58%
2 Crores to 5 Crores 39.00% 4.36%
Over 5 Crore 42.74% 4.09%

From the above table it becomes apparent that  post tax return on the RBI bonds is lower as compared to the yield on tax free bonds for persons with income higher than 10 lakhs. So for those with taxable income upto Rs. 10 lakhs it does not make sense for them to invest in tax free bonds. Even if we take into account the brokerage charges payable on purchase of these bonds, I feel even the cut off limit for investments will go higher to those with income over 50 lakhs. The interest rate offered by RBI bonds is externally linked to NSC. It is perceived that the interest rates have reached their bottom except for maximum one or two small rate cuts so the interest rate cycle will reverse sooner than later. Once the interest rate cycles reverses, the coupon rate on these bonds will go up and post tax yield will also go up.  So in case you wish to invest your money for seven years, and your income does not exceed 50 lakhs, it makes sense for you to put your money in RBI bonds than going for tax-free bonds just to have no tax liability taking into account the indicative yields and probability of interest rates going up in near future.

After the detailed discussion my friend was convinced and threw away the idea of investing his retirement savings in tax free bonds as his income post retirement was not going to exceed the threshold of 50 lakhs.

The writer is a tax and investment expert and can be reached on jainbalwant@gmail.com

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One Comment

  1. Zarir Wadia says:

    Need help in filing tax returns. I have been an nri for last 40 years and now for last 2.5 years have retired and residing in mumbai. I have changed my bank account from nre to resident account and also pancard address changed to local address. I have not ever filed any tax retuns and am completely novice in that matter.
    Please let me know what all documents are required to start with this.

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