What are Tax Exempt Bonds?

What is the Maturity Period for Tax Exempt Bonds? What are Tax Exempt Bonds? What is the Interest Rate on Tax Exempt Bonds? Who can Issue Tax Exempt Bonds?

Tax-free bonds are very popular these days as the interest income produced from them is not taxed. Because these bonds are produced by government agencies, there is very little chance of non-payment of interest. The interest rate on tax exempt bonds is also fixed. The proceeds from these bonds are typically used to fund infrastructure projects. Since the primary amount invested in tax-free bonds doesn’t somehow eligible for a tax deduction as per Section 80C, it is best to declare your interest income as the principal amount. Let us dive in deeper and learn more about tax exempt bonds and tax free bonds.

1. What are Tax Exempt Bonds?

A government enterprise issues tax-free bonds to raise revenue for specific initiatives and welfare schemes. Municipal bonds generated by municipalities are one type of this bond. They provide a set interest rate and are rarely defaulted upon, making them a low-risk investment option. The tax-exempt sectors generally refer to either a market segment made up of investment vehicles or non-profit organizations that are exempt from paying federal taxes.

Tax exempt bonds are bonds with a predetermined rate of interest as yield, but the yield on these bonds is tax-free, which means that the investor pays no tax on income. These bonds are frequently connected with a collection of investments that provide tax-free interest or dividends. Bonds, notes, leases, bond funds, mutual funds, money market funds, trusts, life insurance, Roth IRA earned income, Coverdell Education Savings Account distributions, Health Savings Account (HSA) payouts, and fixed annuities are all examples of investments in this sector.

Long-term maturity periods for tax-free bonds are 10, 15, and 20 years. Power Finance Corporation, Indian Railway Finance Corporation, and NHAI are among the largest issuers of tax-free bonds in India. (See Why Do You Have To Pay Taxes?)

2. What Type of Bonds are Tax Exempt?

There are two types of tax-exempt municipal bonds based on how the money borrowed is repaid: general obligation (GO) bonds and revenue bonds.

  • Because the taxing authority normally raises cash to satisfy any GO bond obligations, government municipal bond producers provide a guarantee.
  • Revenues earned from tolls, leases, or infrastructure expenses are utilized solely to settle revenue bond obligations.

3. What is the Interest rate on Tax Exempt Bonds?

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Tax-free bonds are issued by many organizations and institutions, and the interest rate on tax exempt bonds typically ranges from 7.3 to 7.5% per year, depending on the ratings of the bond which are decided by the credit rating agencies. (See What is the difference between public debt and external debt?)

4. How does Tax Exempt Bond Work?

A bond is an instrument bearing a fixed rate of interest as a yield. Similarly, tax exempt bonds are bonds carrying a fixed rate of interest as yield but the yield on these bonds is exempted from tax. It means that the investor has to pay no tax on income from tax-exempt bonds.

These bonds are issued for periods ranging from 10 years to 20 years. They are issued in the primary market but can also be traded in the secondary market where market forces of demand and supply work to determine the price of the bond. The interest rate on bonds varies based on the rating of the bond from credit rating agencies. These bonds are a common way of raising funds for many public undertakings like IRFC, PFC, NHAI, and the Indian Renewable Energy Development Agency. (See How is Demand used in Economics?)

5. Who can Issue Tax Exempt Bonds?

Tax exempt bonds are issued by various companies and enterprises which are: 

  • A government enterprise or public sector companies issue tax exempt bonds to raise funds for certain projects or initiatives.
  • Municipal bonds issued by municipal companies are an example of these bonds because they have a fixed interest rate and hardly default, making them a low-risk investment option.
  • For example, National Highways Authority of India (NHAI) bonds are tax-free, with the earnings going toward highway infrastructure development in India. Also, it is exceptionally safe and has no default risk because they are issued by the government.

6. Are Capital Gains on Tax Exempt Bonds Taxable?

If the interest income bonds are converted into the money before their maturity date, the amount invested on which the tax exemption was claimed is taxed as a long-term financial return during the year of conversion. Such bonds have interest that is taxable to the bondholder. The interest income is taxed at the slab prescribed rate towards the taxpayer for the fiscal year under the heading income from other Sources. By investing in such bonds, you can claim an exemption of up to Rs 50 lakhs under Section 54EC. (See What is Accounts Receivable with Recourse?)

7. Are there any Tax Free Bonds Available?

Yes. Tax-free bonds are a very lucrative investment as the investor has to pay no tax on the yield of such bonds; they are available in both Demat and physical forms. Indian railway finance corporation tax-free bond, Power finance corporation tax-free bond, and NHAI tax-free bond are a few examples of tax-free bonds. (See What are the Disadvantages of Foreign Direct Investment?)

8. Are RBI Tax Free Bonds Available?

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Yes. The Government of India announced the issuance of 8% Savings Taxable Bonds in the year 2003 which came into effect on April 21, 2003, to allow residents, charitable institutions, and universities to invest in a taxable bond with no monetary limitations. The bonds’ primary characteristics are: 

  • Who may invest: Joint Holdings, Hindu Undivided Families, charitable organizations, and universities may all invest in the bonds however, they are not available to non-resident Indians.
  • Subscription: Applications for bonds in the form of Bond Ledger Accounts will be accepted at about 1600 authorized branch offices of agency banks and SHCIL.
  • Issue Price: The face value of these bonds will begin at a minimum of Rs. 1000 and increase from there. They will be issued at par or 100% of the initial amount. As a result, the issuance price for each rupee of one thousand rupees will be Rs. 1000 as nominal, and Demat bonds will be issued only for Bond Ledger Accounts.
  • Period: The bonds will be available until further notice and will be issued in both cumulative and non-cumulative formats.
  • Limitations on investment: There won’t be a maximum amount or limit that can be invested in the bonds.
  • Income-tax: Depending on the appropriate tax status of the bondholder, interest on the bonds will be subject to taxation under the Income-tax Act of 1961.
  • Wealth tax: Bonds will not be subject to wealth tax under the 1957 Wealth Tax Act.
  • Maturity and interest rate: The bonds will mature in 6 years and bear interest at 8% per annum, payable semi-annually. At the end of six years, the cumulative value of Rs.1000 will be Rs.160.
  • Transferability: The bonds are neither transferrable nor tradeable in any secondary market, and they cannot be used as collateral to secure loans from banks, non-banking financial companies, or financial institutions.
  • Nomination: A nomination can be made by an individual who is the single holder or sole living holder of a bond.

9. How do you buy Tax Free Bonds?

Tax-free bonds are issued by certified agencies in the primary market and are bought via subscribing to the said issue, but these bonds are also available in the secondary market for trade and can be bought in both National Stock Exchange and the Bombay Stock Exchange. It is to be noted that the price in the secondary market is subject to volatility based on demand and supply. (See How are Humans Economics and Ecology Linked?)

10. Which Investment is Tax Free?

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These investments are tax-free:

  • Life Insurance
  • PPF (Public Provident Fund)
  • NPS (New Pension Scheme).
  • Pension
  • SCSS (Senior Citizens Saving Schemes)

The most important benefit of tax free bonds, other than the absence of risk, is that they generate tax-free income. According to Section 10 of the Income Tax Act of 1961, the interest you earn from tax-free bonds is not subject to taxation. When you buy a conventional bond or a bank FD, the interest income is applied to your tax bracket and taxed accordingly. As a result, if you are in the highest tax rate, your interest income will be taxed at 30%. However, with tax-free bonds, even if you are in the 30% tax bracket, your tax liability is zero. As a result, tax-free bonds are particularly popular among high-net-worth individuals. (Also read How Globalization affects your Daily Life?)

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