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How your debt investments are taxed

Keerthi Sanagasetti | Updated on December 07, 2019 Published on December 07, 2019

Tax rates governing the instruments can be quite diverse at all the three stages — at the time of investment, while receiving regular interest income and at maturity or sale

Just as it takes all kinds to make the world, there are all kinds of instruments in the fixed-income bucket. This category has expanded over the years from the plain-vanilla bank fixed deposits and post office savings accounts to the somewhat more complicated debt mutual funds. The wide array in fixed-income instruments provides multiple choices for investors across the risk spectrum.

But while evaluating the potential returns from fixed-income instruments, investors need to factor in the tax incidence. After all, what really matters to you as an investor is the post-tax return. The tax incidence governing fixed- income instruments can be quite diverse at all the three stages — at the time of investment, on regular interest payouts/accruals and on redemption/maturity or sale.

With policymakers having to do a delicate balancing act between trying to goad investors to save through tax incentives on certain investments, and making sure that undue tax advantage is not available on too many instruments, investors have their task cut out while choosing fixed- income investments. We attempt to make the task simpler for you by explaining the tax incidence on some popular fixed- income categories such as bonds/debentures, deposits including post office schemes, debt mutual funds and retirement planning products.

Bonds and debentures

Bonds and debentures are issued by public as well as private companies.

Tax break on investment

Apart from regular returns on investment in the form of interest payments, certain bonds can fetch you additional tax savings in the year of investment. Section 80C of the Income Tax Act allows the subscription to notified bonds issued by some institutions, such as the rural bonds issued by NABARD, to be claimed as a deduction from total income.

Do note that the maximum amount that can be claimed as a deduction under Section 80C (including tuition fees, contributions to provident funds, premium for life insurance, pension schemes of LIC and other insurers, etc) is ₹1.5 lakh a year.

If you have tax liability in the nature of long-term capital gains (LTCG) on sale of land or building (or both), investment in certain specified bonds, such as bonds issued by NHAI, REC, PFC and IRFC can reduce your tax burden. Section 54EC exempts such LTCG to the extent of investment in these bonds (up to ₹50 lakh).

The issues of NHAI, REC, PFC and IRFC bonds are currently open — you can invest in these to reduce your tax outgo. Investors need to, however, note that investment in these bonds should be made within six months of sale of the land or the building.

Payouts during tenure

The regular payouts from bonds — in the form of interest or coupon payments — are taxed under the head ‘Income from Other Sources’ (IOS), unless exempt. However, the Centre has notified certain bonds with long tenures of, say, 10, 15 or 20 years, as tax-free bonds, interest payout on which is exempt from tax. For instance, interest earned on certain long-term bonds issued by IRFC, PFC, NHAI, HUDCO, REC, NTPC, NABARD and Indian Renewable Energy Development Agency (IREDA) are exempt from tax.

Investors should not confuse these tax-free bonds for tax- saving bonds (such as capital gains bonds issued by IRFC, covered above) which allow rebate on investment only.

The primary issue of tax-free bonds happens only when the Centre authorises their issue in the Budget. But some such bonds that have reasonably good liquidity can be purchased on the secondary market on the stock exchange platforms.

However, in the case of notified rural bonds of NABARD, the payouts, too, are tax-exempt.

Sale or redemption

On sale or redemption of bonds, the difference between the sale price and the cost of acquisition shall be subject to tax. The rate at which the gains shall be taxed will depend on whether the same is short- or long-term.

LTCG on bonds listed and traded on exchanges are taxed at 10 per cent (without indexation) if held for more than 12 months. In case of unlisted bonds, LTCG will be taxed at 20 per cent without indexation, if held for more than 36 months. Short- term capital gains on bonds shall be taxed at the investor’s applicable slab rates.

Sovereign Gold Bonds

Sovereign Gold Bonds (SGBs) are generally issued with a tenure of eight years. The annual interest earned on these bonds (currently at 2.5 per cent) is taxable under IOS.

If the bonds are redeemed from the RBI, there is no capital gains tax payable. The RBI permits such redemption from the fifth year onwards.

However, since SGBs are listed on the stock exchanges, investors may offload the same in the secondary market, anytime. In such instances, LTCG tax at 20 per cent, with indexation benefit, shall apply if the SGBs are held for more than 36 months.

Investors of SGBs can, however, also opt to pay LTCG tax at 10 per cent without indexation benefit, if it works out to be lower. In cases where the period of holding an SGB does not exceed 36 months, the gains on sale shall be taxed as short-term, at the investor’s applicable slab rates.

 

 

 

Bottom-line: While tax- saving bonds can be beneficial, the overall limit under Section 80C curbs the deduction at ₹1.5 lakh a year. For those of you who have already exhausted this limit, tax-free bonds can help lower the tax outgo.

Deposits

Deposits of varying tenures are offered by banks, post office and companies, among other entities.

Rebate on investment

Tax savings are not just limited to specified bonds issued by government-run entities. Many banks, too, offer tax-saving fixed deposits, investments in which can be claimed as a deduction under Section 80C. These are essentially time deposits with notified banks; such deposits have a tenure of five years or more.

Besides, investments in certain notified deposit schemes of National Housing Bank, or a public sector company engaged in providing housing finance, and other notified institutions such as HUDCO, can also be claimed as deduction under 80C.

Payouts and maturity

Interest earned on fixed deposits with banks or other corporates is taxed as IOS as per the investor’s slab rates. Senior citizens can claim a deduction of up to ₹50,000 a year on interest earned on any deposits with banks, cooperative societies and post office.

For others, interest of up to ₹10,000 on savings deposits with banks or Post Office is allowed as deduction.

In non-cumulative deposits, the interest paid is to be declared for tax purposes on a regular basis. In cumulative deposits, the excess over the amount invested in the deposits will be taxed as interest under IOS.

You can choose to declare the interest on a regular (accrual) basis or at the end of the investment period on a cash basis. But if the bank/corporate cuts tax deducted at source on a regular basis, it will be better to declare the interest income, too, on an accrual basis for easy tax- adjustment claims.

Bottom-line: If you wish to park a portion of your investments in bank FDs, consider tax-saving deposits (minimum tenure of five years) to enjoy tax benefits on investment.

Post Office savings schemes, small savings schemes

Investment in certain small savings schemes and Post Office savings schemes such as the Public Provident Fund (PPF), Senior Citizens Savings Scheme (SCSS), National Savings Certificate (NSC), Sukanya Samriddhi Scheme and five-year time deposit with Post Office, are eligible for deduction from the total income under Section 80C.

In other small savings schemes, such as the Kisan Vikas Patra and Post Office Monthly Income Scheme, such deduction is not applicable.

 

 

 

Payouts and maturity

Interest payouts on Post Office savings accounts, recurring and time deposits, and National Savings Monthly Income Scheme will be taxable as IOS every year.

All payouts from PPF and Sukanya Samriddhi Scheme are exempt from taxes. In the case of NSC, the interest earned during the tenure should be taxed as IOS every year (on an accrual basis). However, the interest earned every year can be claimed as reinvested and shown as a deduction under Section 80C. Hence, effectively, only the interest accrued in the last (fifth) year will be taxed under IOS in NSC.

In the case of SCSS, interest is paid on a quarterly basis and taxed at the investor’s slab rates. But a senior citizen can claim deduction of up to ₹50,000 a year on such interest along with interest earned on any deposits with banks, cooperative societies and post office.

 

 

 

Bottom-line: Among the Post Office savings schemes, only the PPF and Sukanya Samriddhi enjoy the tax exempt-exempt-exempt (EEE) status, but they come with caveats. The maximum investment in a year is ₹1.5 lakh for both, and you can invest in the latter only if you have a girl child.

Retirement planning

Investment products that aid in retirement planning have different taxation aspects. Various pension schemes offered by insurers, the National Pension Scheme (NPS) and the Pradhan Mantri Vaya Vandana Yojana (PMVVY) operated by the Centre are examples of retirement-oriented investment products.

These products essentially accept investments (either lump sum or in instalments) over a period.

The earnings on these contributions are available for withdrawal (along with the corpus) only after a specified period of time (or after attaining 60 years of age).

In certain cases, such as the NPS, the investor also has the option of withdrawing a part of the maturity value after a specified period and receive the remaining over the lifetime after retirement — as pension or annuity.

 

 

 

Rebate on investment

Contribution to pension schemes of LIC and other private insurers can be claimed as a deduction from total income under Section 80C, up to ₹1.5 lakh a year. Contribution to the Employees’ Provident Fund (EPF), including voluntary contributions, can be claimed as a deduction under 80C.

The Centre has also notified certain other pension schemes which can be claimed as a deduction under Section 80CCD; for example, the National Pension Scheme (NPS) and Atal Pension Yojana.

The maximum amount that can be claimed as a deduction under Section 80CCD is 10 per cent of salary (basic plus dearness allowance), for contributions made as an employee.

For self-employed individuals, such limit will be calculated at 20 per cent of gross total income. Note that this is included in the overall limit of ₹1.5 lakh under Section 80C.

However, additional contributions to notified schemes such as NPS is available for an additional tax break of ₹ 50,000 a year — over and above the ₹1.5-lakh limit of Section 80 C.

Investments in other schemes, such as the PMVVY, do not offer tax savings on investment.

Payouts and withdrawal

In certain retirement-oriented products, after the expiry of a stipulated period (varies for different schemes), investors can either opt for a lump-sum withdrawal or periodical payouts (as pensions or annuity).

Such withdrawals or pension received in any FY will be taxed as IOS, unless they are exempt from tax.

The exemptions on withdrawals vary for different schemes.

For instance, in the case of NPS, such withdrawals are exempt up to 60 per cent of the total corpus on closure of the scheme. The remaining amount is utilised to purchase an annuity under the scheme.

The payout from such annuity will, however, be entirely taxed as IOS in the year of receipt.

For certain other schemes, for example pension schemes of private insurers, the Income Tax Act only exempts one-third of the withdrawal on retirement. The remaining amount shall be taxable as IOS in the year of receipt.

The EPF enjoys an EEE status, but some conditions apply.

The interest earned on EPF contributions is tax- exempt up to 9.5 per cent per annum. While the interest earned above such percentage is taxable, investors should note that the EPF has not exceeded the said rate in the past few years.

In the case of withdrawals, proceeds from the EPF at the time of maturity (retirement) are tax-exempt. Premature withdrawals are tax-exempt only if the employee completes five years of continuous service (not necessarily with the same employer). If contributions to the EPF are withdrawn before five years of continuous service, the same shall be taxable as IOS at the maximum marginal rate.

For other schemes that offer pension, such as PMVVY, no such tax breaks are available. Hence, the pension payouts from the same will be taxed as IOS.

Bottom-line: Considering the tax savings, contributions to EPF and NPS score over other retirement schemes.

Debt mutual funds

Though debt mutual funds essentially invest in fixed- income securities, they don’t guarantee regular payouts. In the growth option, regular earnings are not paid out, but re-invested. Hence, taxability arises only on redemption of the fund units — gains are taxed as LTCG (if the units are held for more than 36 months) at 20 per cent with indexation benefit. Else, short-term capital gains (on sale within 36 months) are taxed at the investor’s slab rates.

If an investor opts for the dividend option (instead of growth), payouts (dividends) shall be exempt from tax in the hands of the investor. While this may appear lucrative, investors need to take note of the dividend distribution tax (DDT) that has to be paid by the mutual fund on the same.

This brings down the net asset value (NAV) and the effective return earned by the investor.

The current rate at which DDT is required to be paid by debt mutual funds is 29.12 per cent, including surcharge and cess (38.82 per cent after grossing up), making this option unattractive in most cases.

Bottom-line: If managing fixed-income investments is not your cup of tea and you wish to trust experts with managing your money, debt mutual funds could be your choice. However, keep in mind that the funds do not guarantee regular payouts, unlike regular bond investments. Go for the growth option and choose systematic withdrawal plan to withdraw cash, if you want to, after 36 months, for tax-efficient returns.

Published on December 07, 2019
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