Tax-Free vs Tax-Saving Bonds: Which One Should You Choose to Save More Tax?

Bonds are a part of fixed-income securities. They provide stable and consistent returns over the investment period and hedge the risk of investing in equity instruments. However, this is not all. A few bonds, such as tax-free bonds and tax-saving bonds, also help you to save the outgoing on tax liabilities. How? Let’s find out.

What are Tax-free Bonds?

Tax-free bonds are issued by the central or state governments to raise funds for particular projects. Tax-free bonds provide tax-free returns. One example of these bonds is the municipal bonds that municipal corporations issue. You can invest up to Rs. 5 lakhs under this bond category for a fixed period of 10, 15, and 20 years.

The expected return you can expect by investing in tax-free bonds is around 7.3% to 7.5%. The return also depends on the rating of bonds. The interest rate is fixed, and the interest income you earn on tax-free bonds is exempted under section 10 of the Income Tax Act. There is no TDS, either.

Let’s take an example. If you invest Rs. 1,00,000 today in a tax-free bond at a coupon rate of 7.3% for a lock-in period of 10 years, at maturity, you will receive Rs. 202,300. The interest income is Rs. 1,02,300, which is entirely tax-free. Not a bad deal, is it? However, if you sell these bonds in the secondary market, if they are listed, you will have to pay tax on capital gains.

Because the government backs these bonds, insolvency is never a concern. The funds collected via tax-free bonds are usually invested in infrastructure and housing projects.

Who Issues Tax-Free Bonds?

Tax-free bonds in India are issued by government-backed entities and public sector undertakings (PSUs) to fund large-scale infrastructure and development projects. These bonds are considered safe due to sovereign backing, offering low credit risk to investors.

Notable issuers include:

• National Highways Authority of India (NHAI)
• Power Finance Corporation (PFC)
• Housing and Urban Development Corporation (HUDCO)
• Indian Railways Finance Corporation (IRFC)
• Rural Electrification Corporation (REC)

The proceeds from these tax-free bonds typically go into sectors like housing, power, highways, and urban development—aligning your investment with the nation’s growth.

What Are The Benefits Of Tax-Free Bonds?

Tax-free bonds offer a blend of safety, tax efficiency, and long-term growth. Key benefits include:

• Tax-Exempt Interest Income:The interest earned is completely exempt from income tax, making these bonds especially attractive to high-income earners in higher tax slabs.
• High Safety:Since these are issued by government-backed entities, the risk of default is minimal.
• Predictable Income:With fixed interest payouts (usually annually), investors enjoy a stable income stream.
• Long Investment Horizon: Most tax-free bonds have a tenure of 10–20 years, suitable for long-term wealth planning and retirement.
• No TDS:Interest payments are not subject to Tax Deducted at Source, ensuring full receipt of income.

These benefits make tax-free bonds attractive for investors in higher tax brackets seeking steady income with tax savings.

How To Buy Tax-Free Bonds?

Investing in tax-free bonds in India is easy and accessible. Here’s how you can buy them:

1. Primary Market

When a new issue opens, you can apply online or offline through banks, brokers, or registered financial advisors.

2. Secondary Market

Listed tax-free bonds can be bought or sold on stock exchanges like NSE and BSE. Prices may vary depending on demand and interest rate movements.

3. Eligible Investors

Retail investors, NRIs, HUFs, and High Net-Worth Individuals (HNIs) are all eligible to invest, subject to scheme-specific terms.

4. KYC Documents Required

You’ll need a PAN card, proof of address, and bank account details to get started.

5. Use Online Platforms

Many modern digital investment platforms and brokers now allow seamless bond purchases with transparent pricing and easy tracking.

Always review the bond’s tenure, coupon rate, and issuer credibility before investing.

Additional Read - Types of Capital Markets in India

What are Tax-saving Bonds?  

If you want to reduce your tax liability, investing in tax-saving bonds can be a good option. Under section 80CCF, you can invest Rs. 20,000 per year by investing in these bonds above Rs. 1.5 lakh exemption under section 80C. This deduction can be added with other deductions to lower the tax liability. (The same tax implication applies to government-issued infrastructure bonds.)

Tax-saving bonds issued by the government offer interest of 7.75%-8% and have a typical lock-in period of 5 years. There are often clauses of buyback after the initial 5 years. The interest income you receive by investing in this bond is taxable.

If you are wondering why you should invest in tax-saving bonds instead of tax-saving FDs, the answer is higher returns. The return you can expect by investing in a tax-saving bond is 7.75-8%, while the same for tax-saving FD ranges from 5.50% to 7.75%.

Also, a tax-saving FD has a fixed term of 5 years and offers tax exemption of up to Rs. 1.5 lakh under Section 80C. On the contrary, tax-saving bonds offer an additional exemption of Rs. 20,000 beyond Section 80C. So, all in all, the benefits you can receive from these bonds outweigh the benefits of tax-saving FDs.

Tax-Free Bonds vs Tax-Saving Bonds: Key Differences

Tax-free bonds and tax-saving bonds are both popular investment options, but they differ significantly in structure, tax treatment, and tenure.

1. Tax Treatment

• Tax-Free Bonds: The interest earned is fully exempt from income tax under Section 10(15). No TDS is deducted.
• Tax-Saving Bonds: You get a deduction of up to ₹20,000 under Section 80CCF on the principal invested. However, the interest earned is taxable as per your income slab.

2. Interest Rates

• Tax-Free Bonds: Offer moderate coupon rates of 7.3%–7.5%, which are more effective post-tax for high-income investors.
• Tax-Saving Bonds: Offer slightly higher nominal interest (7.75%–8%), but the effective return reduces after taxation.

3. Tenure & Lock-In

• Tax-Free Bonds: Typically have a long-term maturity of 10–20 years. No mandatory lock-in; tradable on stock exchanges.
• Tax-Saving Bonds: Come with a mandatory 5-year lock-in period. Maturity usually ranges between 5–10 years.

4. Liquidity

• Tax-Free Bonds: Can be sold in the secondary market, offering better liquidity. However, capital gains tax may apply.
• Tax-Saving Bonds: Non-tradable during the lock-in. You must hold till maturity

Understanding these differences can help you choose the right bond for your investment horizon, tax bracket, and financial goals.

Conclusion

Both tax-fee and tax-saving bonds are good investment options. The first provides tax-free returns, and the latter allows tax exemptions. Based on your requirements, you can decide to include them in your investment portfolio.

Additional Read - Why Bonds Are the Safest Investment Option in Today’s Market

Frequently Asked Questions (FAQs)

1. What exactly is the maturity of a tax-saving bond?

Tax-saving bonds usually have a maturity ranging from 5 to 10 years, with a mandatory 5-year lock-in period. During this lock-in, the bonds cannot be sold or transferred. Some may offer a buyback option after the lock-in period, subject to issuer terms.

2. Do tax-exempt bonds get taxed on maturity?

No, the interest earned on tax-free bonds is fully exempt under Section 10(15) of the Income Tax Act. However, if you sell these bonds before maturity on the secondary market, capital gains tax may apply. Otherwise, the principal and interest are not taxed if held until maturity.

3. What is the maturity of a tax-saving bond? 

The maturity of tax-saving bonds generally ranges from 5 to 10 years, with a compulsory 5-year lock-in period. These bonds cannot be sold before maturity, ensuring the investment stays locked.

4. What are 5-year tax-free bonds?

There are no typical "5-year tax-free bonds" as tax-free bonds usually have longer tenures of 10 to 20 years. Tax-free bonds offer tax-exempt interest income and are government-backed, but their tenure is generally long-term rather than 5 years.

5. Are savings bonds always tax-free?

Not necessarily. The tax treatment depends on the bond type:

• Tax-Free Bonds: Interest is fully exempt from income tax.
• Tax-Saving Bonds: Offer a deduction on investment amount, but the interest earned is taxable.
  So, always check whether the bond is classified as tax-free or tax-saving before investing.