One of the fresh tax reliefs that has come as an outcome of the budget 2010 is the deduction allowed for investing upto Rs 20000 in the infrastructure bonds. Many articles and the FM have said that this is a very positive thing. But how can the same thing be positive for every individual. If not negative it should at le
ast be neutral for many.
Else life would be so boring. This article will try to look the pros and cons of investing in Infrastructure bonds for the sake of tax saving. The analysis will be from the perspective of the different “tax groups” post budget 2010.
- Tax group 1: Taxable income Rs. 1.6-5 lakhs
- Tax group 2: Taxable income Rs. 5-8 Lakhs
- Tax group 3: Taxable income above Rs. 8 lakhs
Parameters
To understand the pros and cons of any tax saving investment we need to look at 4 major parameters
Actual tax saving (let’s take the highest saving possible).
Returns from the investment (during the lock in period at the least).
Opportunity cost (what if the same money had been invested in some other investment?).
Effect of Inflation on the returns on investment (what would the worth of your investment be when it comes to redeem/encash it?).
Assumptions
For the sake of parameter two we will have to take an assumption on the lock-in period (as nothing has so far been announced by the Finance Minister). As is generally the case with most tax saving instruments we can assume two scenarios – 3 year lock-in and 5 year lock-in
Let’s assume the rate of return on infrastructure bonds = 5.5% per annum.
Let’s consider overall rate of inflation to be 8%. (Food inflation itself is currently at 18 %).
For people in the 1.6- 5 lakh taxable income group, as per the new norms the income will be taxed at a rate of 10%.
Savings
Parameter 1: Actual tax saving: 10% of Rs 20,000 = Rs 2000 (if you invest Rs 20000 in the instrument you get to reduce your taxable income by 20,000 thus giving a 10% benefit)
Parameter 2: What will be the returns at the end of the lock in period? For a lock in period of 3 years an investment of 20000 would fetch an income of Rs. 3484. When added to the tax saved we get an effective return of Rs 25485 (Rs 20000 + 3484 + 2000) on our investment.
Parameter 3: If this same amount were to be invested in a market instrument that fetched a return of 15% (which is very reasonable considering that the benchmark Sensex and many mutual funds have given comparatively higher returns on a long period.) the investment would fetch an effective return of Rs 27, 376 (Rs 20000-2000=Rs 18000 invested @15% per annum for 3 years).
Countering Inflation
Parameter 4: What would be the minimum amount required to counter inflation at 8%? The amount would be Rs 25, 194.
Thus we see that for a person in the slab of 1.6-5 lakh the benefit out of investing in an infrastructure bond as a tax saving instrument will be only Rs 291 (Rs 25485-25194) whereas the benefit out of paying the tax and investing the balance in any decent instrument would be Rs 2182.
Click here to see the benefits for each segment as well as for a scenario where the lock in period is 5 years.
As seen from the table, it makes sense for people in the >Rs 8 lakh taxable income slab to use the infrastructure bonds as a tax saving instrument. For the people in the 5-8 lakh bracket it would be advisable to invest in infrastructure bonds if the period of investment is 3 years but not for five years and for those in the 1.6-5 lakh bracket it would be an absolute no-no to invest in Infrastructure bonds for tax saving purpose.
VERY GOOD ANALYSIS, EYE OPENER
These bonds may be positive because these would be risk free as notified by the central govt.
Secondly, there will be additional deduction of Rs. 20000.
Regards
Rekha
What is the Rate of Interest for Infra. Bond
This provides an additional investment and tax-saving avenue for investors. The total savings limit for individuals is now Rs 1.2 lakhs. By investing in infrastructure or tax-saving bonds, you can save on taxes as provided under the Income Tax Act 1961.
Two important factors playing a vital role while choosing infrastructure bonds to invest in are inflation and interest rate movements . For instance, the price of a bond will fall if interest rates rise and vice versa.
Infrastructure bonds reduce your tax liability. You have the option of purchasing and holding the instruments either as physical certificates or in the demat form. These come in two categories – regular interest or deep discount bonds. These bonds are issued at a discount . After the tenure, they are redeemed at their face value. A zero-coupon bond has no coupons attached and there is no interest paid. But at maturity, the issuer promises to redeem the bond at face value. The maturity dates on zero coupon bonds are usually long-term . Many don’t mature for 10 or more years. These long-term maturity dates allow an investor to plan for a longrange goal, such as paying for a child’s college education .
With the deep discount bond, an investor can set aside a small amount of money that can grow over many years. Obviously, the original cost of a Rs 1,000 bond is much lesser than Rs 1,000. The actual price depends on the holding period – the number of years to maturity, the prevailing interest rates, and the risk involved (for the bond issuer). In order to find the yield of the bond, you need to consider the par value, the purchase price and the time until maturity. Infrastructure bonds do not offer any protection against high inflation since the rate of interest they offer is predetermined. These can be pledged with a bank to borrow. The amount you can get depends on the market value of the bond and the credit quality of the instrument .
Some key features of these bonds:
The motive behind investing in infrastructure bonds is to save tax. Investments in other products like mutual funds are market-linked and returns are not assured, and thus the rate of returns may not be repeated in the future. The risks associated with mutual fund investments are much higher as compared with these bonds. Investors who want to invest in risk-free avenues might be unwilling to venture into market-linked products.
How it works for you
Considering the tax savings , the effective yield on these bonds comes out to be quite good. In case you invest Rs 20,000, in these bonds, you can claim a deduction of Rs 20,000 in addition to the Section 80C deduction. At the highest tax rate of 30 percent , this translates into a saving of Rs 6,000 in taxes, which is available upfront.
In case the interest rate offered is eight percent, you will get interest on Rs 20,000 i.e. Rs 1,600. However, this would be on a net investment of Rs 14,000 (considering the tax benefit). As such, the net yield is 11.43 percent (Rs 1,600 divided by Rs 14,000). It is to be kept in mind that the interest earned may or may not be tax-free . Usually, the interest earned is taxable in the hands of the individual.
Article Rockzzzzzzzz
Very useful article for those paying income tax.
introduction of infrastructure bonds is positive step. return on mutual funds and/or in stock market can be negative also but in these bonds capital is safe. so good step by finance minister.
please share details on how many infrastructure bonds we can have
please guide me, i want to buy infracture bond which is under 20000 new tax limit