Tax-free bonds

Most interest income in India is taxed at the investor's slab rate. Tax-free bonds are the exception: the interest is not taxed in the investor's hands at all.

The market is not generous about this. Because the investor keeps the whole coupon, these bonds are issued at a lower interest rate than taxable bonds of similar credit quality and tenor. Whether a tax-free bond is actually the better deal therefore depends on the investor's own tax bracket — which is the calculation the paper tests.

For a retiree they have been a natural income product: long tenors, public-sector issuers, and income that does not add to taxable income.

Issuers and tenor. The workbook names HUDCO, NHAI, PFC, REC and IRFC — public sector enterprises in the infrastructure sector — with tenors of 15 to 20 years.

Availability. No fresh tranches have been issued since FY 2015-16. The bonds are available only in the secondary market on the stock exchanges, from an outstanding pool that is fixed and shrinks as bonds reach maturity.

Comparing with a taxable investment. Bring both to the same footing, either post-tax or pre-tax:

• Post-tax return of a taxable product = taxable rate × (1 − tax rate)
• Pre-tax equivalent of a tax-free rate = tax-free rate ÷ (1 − tax rate)

Two uses in retirement income planning (Chapter 7):

1. Covering essential living expenses from income that carries a tax benefit, after the pension and annuity have covered the mandatory ones.
2. Staying inside a tax bracket. Tax-free interest can bridge the last slice of income a retiree needs without pushing taxable income into the next slab.

Do not confuse them with the infrastructure bonds of financial institutions such as IDBI, IIFCL and NABARD, which the workbook describes as eligible for a deduction on the investment under section 123 read with Schedule XV of the Income-tax Act, 2025 — a different benefit at a different stage.

Taxable-equivalent yield = Tax-free yield ÷ (1 − tax rate)

Post-tax yield of taxable product = Taxable yield × (1 − tax rate)

The workbook's comparison. A tax-free bond pays 8 percent; a taxable bank deposit pays 9 percent; the investor is in the 20 percent bracket.

Post-tax:  deposit = 9% × (1 − 0.20) = 7.2%   vs  bond 8%
Pre-tax:   bond    = 8% ÷ (1 − 0.20) = 10%    vs  deposit 9%

Both routes say the tax-free bond wins.

The break-even rates for a 7 percent tax-free bond (Chapter 7):

In rupees (illustrative). A retiree in the 30 percent bracket has Rs 10 lakh to place:

Tax-free bond at 7%:  interest Rs 70,000, tax nil          → Rs 70,000
Taxable deposit at 9%: interest Rs 90,000, tax Rs 27,000   → Rs 63,000

The lower coupon leaves her Rs 7,000 a year better off. For an investor in the 5 percent bracket the same deposit would leave Rs 85,500 after tax and the tax-free bond would lose.

Chapter 5, section 5.6.1 (Tax-Adjusted Returns), uses tax-free bonds for the post-tax versus pre-tax comparison. Chapter 3, section 3.4.2, describes the issuers, the 15-20 year tenors and the absence of fresh issues since FY 2015-16, and Chapter 7, section 7.5, uses them for the bracket break-even rates and for keeping a retiree in a lower slab. Expect a taxable-equivalent yield computation and the "which is better for this bracket" judgement.

• Tax-free does not automatically mean better. For a low-bracket investor, a taxable product paying above the break-even rate (7.37 percent at 5 percent tax, for a 7 percent bond) gives more after tax.
• Divide to gross up, multiply to net down. 8 ÷ 0.8 = 10 percent pre-tax equivalent; 9 × 0.8 = 7.2 percent post-tax. Swapping the operations is the standard slip.
• No new issues since FY 2015-16. A question implying an investor can subscribe to a fresh public issue is wrong; purchase is in the secondary market only.
• Tax-free interest is not a deduction on investment. Infrastructure bonds eligible under section 123 / Schedule XV give a deduction on the amount invested and their interest is taxable — a different product.
• Capital gains on sale are a separate matter. The workbook's tax-free treatment is of the interest.
• Stale illustration. The Chapter 7 example of Rs 10,50,000 of taxable income tipping a retiree from the 20 percent to the 30 percent bracket reflects one slab structure; slab thresholds differ by tax regime and have been revised, so learn the method rather than the threshold.