Tax Free Bonds – who should invests?

This seems to be the season for tax free bonds.  We have already seen issues from REC, HUDCO and IIFCL; and now, PFC and NHPC have join the bandwagon.  Significant efforts are spent by media in analyzing all the issues i.e. what they offer to investors and which is the best one to invest.  In this article, we shall not look into that but focus more on who should invest in such issues and what aspects the investor needs to take care of before investing in tax-free bonds.  Before that, a synopsis of the ongoing PFC and NHPC bond issue.

PFC and NHPC issue

Bond issues for PFC and NHPC are open right now offering bonds for 10, 15 and 20 years for similar tenure.  Below are the brief details about both the bond issues:

The issue is priced at attractive rates which is same for both PFC and NHPC issue.  These being tax free bonds, any interest received on these bonds is tax free. Accordingly, if one considers pre-tax returns, they are higher than what long term debt mutual funds have provided in last 5 years (7.83% p.a. pre-tax returns as per Value Research).

Pre-tax Returns on PFC and NHPC tax free bonds

Interest Rates	Tax Bracket
	10%	20%	30%
8.43%	9.37%	10.54%	12.04%
8.79%	9.77%	10.99%	12.56%
8.92%	9.91%	11.15%	12.74%

Who should invest in such bonds?

The interest rates are excellent, risk is at the nadir and tenure is long term.  So whether all and sundry should invest in such bonds?  The answer obviously is no.  One needs to take care of following aspects before deciding to invest in these and any other tax-free bonds:

1. This is a long term investment.  Though the bonds are listed and can be traded, one needs to assume that they will not get back the money before the tenure of investment.  Even if there is 1% probability of you requiring the money anytime during the tenure, then one should not consider this investment. 
2. The pre-tax returns decreases for investors falling in lower tax brackets.  So in case you are in 30% tax category bracket, the investment makes more sense to you rather than for people falling under 10% tax category bracket.
3. If you have any loans outstanding, whether it is credit card loan, personal loan, car loan, home loan, etc, the money should be utilized in paying back the loan rather than investing in tax free bonds.
4. These bonds offers good returns as compared to debt mutual funds.  In case you are looking for long term investment in debt funds, tax free bonds are also an option to invest.
5. People on the verge of retirement can replicate this as a pension plan with regular income.
6. PPF returns are almost at par with returns on tax free bonds, however PPF offers more flexibility in withdrawing the amount when required (e.g. by way of loan) and returns on PPF are cummulative.  Hence one should exhaust PPF investment limit before investing in tax free bonds.

The above list is not exhaustive, but one should take the same into account before investing in tax free bonds.

Are you investing in tax free bonds? Share your reason for investing in the comments section below.

Bachhat @ The Indian Blogger Awards 2013

Bachhat - Harvesting Money has been around for now almost 3 years.  Over this period, the blog has tried to help its readers understand personal finance and investing.  The blog has always tried to avoid doing run of the mill articles and has focused on articles and news which can be of value to its readers.

The blog has been nominated for the Indian Blogger Awards 2013 in 'Personal Finance' and 'Stocks' categories.  Indian Blogger Awards 2013 are hosted by Indibloggers and the winner shall be announced via twitter on the Independence Day.

If as a reader, you have benefited by this blog, we request you to recommend Bachhat for the awards by clicking on the following link and recommending the blog.  Link: http://www.indiblogger.in/iba/entry.php?edition=1&entry=53595

Thanks.

Debt Mutual Funds and Tax Implications – Recent changes in tax rates

Earlier Bachhat had written about how one can use ultra-short term debt funds to maximize post tax returns.  The article spoke about investing in dividend reinvestment plan of such funds, since dividend are effectively taxed at lower rate than short term capital gain rates and hence such funds are tax effective.

The tax rates on debt mutual funds were revised earlier during this year and hence the said article is not relevant in the current scenario.  Based on the revised tax rates, we have tried to analyse and tabulate which type of option (growth or dividend) should be chosen for investment in debt mutual funds.

Revised tax rates on debt fund

For an individual investor, short term capital gains in a debt mutual fund is taxable at tax slab under which such individual falls.  Long term capital gains are taxable @ 20% with indexation benefit and 10% without indexation benefit.  Surcharge @ 10% for taxable income of more than Rs. 1 crore and cess @ 4% shall apply additionally.

For dividend distributed, dividend distribution tax is applicable.  Earlier there was difference in dividend distribution tax rates between liquid / money market funds and other debt funds.  Now this difference has been eliminated and now dividend distribution tax on all debt funds shall be 25% (effective tax rate of 28.325% including surcharge and cess).

Growth or Dividend Option

One can maximize his returns from debt funds by choosing the correct option which has least tax implication.  Things to be considered before choosing a plan are:

1. Time period for investment
2. Tax bracket under which an individual falls
3. Need for regular income

Based on the above three criteria, the best option to choose from is as below:

When regular income is required

Since dividend distribution tax rate (28.325%) is higher than the effective tax rate for investors falling under 10% or 20% tax slab, it is beneficial for them to opt for growth option in case they are looking for investment horizon of less than 1 year and choose systematic withdrawal plan wherein a fixed amount shall be redeemed and paid to the investor at periodic interval.  SWP shall provide source of regular income to them.  However before opting for SWP under growth option, one needs to check out for exit load and commence SWP only after the exit load period. 

For individuals falling under 30% tax slab and in need of regular income, the tax benefit between dividend and growth option is minimal with dividend option slightly beneficial than the growth option.

For investment horizon of more than 1 year, it is beneficial for all investors looking for regular income to choose systematic withdrawal plan under the growth option.

When regular income is not required

For investors not looking for regular income, growth option is best irrespective of investment horizon.  However, there can be marginal tax benefit for investors falling under 30% tax slab by choosing dividend reinvestment option for investment horizon of less than 1 year.

Bachhat’s take

By increasing the dividend distribution tax rate, the tax advantage of dividend option which was available till late year has been eliminated, save for investors falling under 30% tax slab.  If an investor decides to invest in a debt mutual fund, he needs to take into consideration above aspects to increase his post-tax returns.  However one needs to keep in mind that the above analysis is relevant only till the tax rates are kept constant.  In case of any revision in tax rates (which may happen at the earliest in 2014 budget), the above may not hold true. 

Mutual Fund Tax Ready Reckoner for year 2013-2014

Continuing the initiative taken last year to provide a one stop solutions for tax implications on mutual fund investments, Bachhat has updated its mutual fund tax ready reckoner for the year 2013-2014.  

As you all are aware, mutual fund investors need to take into account plethora of tax rates to understand post tax returns.  Bachhat's mutual fund tax ready reckoner is an attempt to simplify and help mutual fund investors to determine the tax impact on their mutual fund investments.

You can view the ready reckoner by clicking on this link.  The link also provide rates for the last financial year (i.e. 2012-2013).