Tax-free vs tax-saving instruments

A coffee time conversation between two colleagues leads to an interesting explainer on tax jargons.

Tina: Have you filed your investment proofs for FY21 yet? The deadline set by the HR team is just around the corner.

Vina: No, I am yet to invest in tax-free instruments for this year.

Tina: What? You mean tax- saving instruments?

Vina: Yeah potato, po-tah-toh! Aren’t they the same thing said differently?

Tina: No. While both tax-free and tax-saving instruments ultimately help in lowering your tax outgo, they aren’t the same.

Vina: Why? What is the difference?

Tina: If you want to save tax on interest or any other incomefrom your investments, you should be investing in a tax-free instrument.

Tax-free bonds issued by State-owned companies such as PFC, NHAI, HUDCO and REC, with a maturity of 10 years or more, are one such example.

You can buy these bonds either during their primary issue or from the secondary market once they get listed.

The existing issues of these bonds currently pay interest rates in the range of 7.6 to 9.0 per cent per annum for varying maturities, and the entire interest income is exempt from tax. Hence, the term ‘tax-free’.

Vina: Oh cool! But in this case, my tax savings are limited only to the extra interest income that I pocket by not having to pay any tax on it, right?

Tina: Yes! If you want to save tax on your existing income, like in your case, you should opt for investing in tax-saving instruments.

Say, your income comes to ₹5 lakh a year. You can invest in certain instruments specified under Section 80C of the Income Tax Act and claim deduction of up to ₹1.5 lakh a year. These include five-year term deposits with banks or the Post Office, deposits in Sukanya Samriddhi Account, contribution to the Public Provident Fund and subscriptions to certain notified NABARD bonds. .

Since investing in these instruments reduces your taxable income and so your tax liability, these are labelled as “tax-saving”.

Remember that income from these tax-saving instruments may or may not be exempt from tax.

Vina: All right, now I get it. They aren’t same at all.

Tina: Yes. Tax-saving instruments help reduce your overall income that is subject to tax, to the extent of investment made. On the other hand, tax-free instruments help you only save tax on the interest income from such instruments.

Vina: Wow, that’s simply put!