Investors have their eyes on how best to increase their returns while reducing their tax obligations. One of the best approaches in such a case is considering tax-free securities. But what are they, and why would you want them in your portfolio? Let’s discuss the basics.
What Are Tax-Free Securities?
Tax-free securities are financial instruments which allow for a certain percentage of the earnings from such instruments to be free of taxation.
For example, in India, interest in tax-free bonds issued by government-supported institutions is eligible for exemption under section 10(15) of the Income Tax Act.
Due to tax benefits on returns, such securities are most favored by investors with a high-income tax level as they allow one to obtain long-term low-risk returns from such investments but in a tax-efficient manner
Why Should You Invest in Tax-Free Securities?
1. Tax Efficiency
One major benefit is the exemption from taxes on earned interest income. This means that the income earned afterwards may be greater than other available fixed income instruments such as fixed deposits and corporate bonds.
2. Low Risk
Tax-free bonds are mainly issued by government sponsored institutions thus investment in these securities is less risky than most of the private sector alternatives.
3. Long Term Investment
These bonds have very long-term investment periods usually between 10 and 20 years making them suitable for an investor who wants to invest and enjoy stable returns after a long time.
4. Predictable Returns
These securities bear fixed interest rates which amount to earnings that come at certain periods thus these borrowers are low-risk investors.
How to Invest in Tax-Free Securities?
It is not that difficult to invest in securities that do not attract any taxes. They are also put on sale on certain issuance dates and can be obtained from the stock exchange or brokers. Some of the crucial things that should be looked into are:
- Issuer credibility: Make sure that the bonds are issued by a reputable government-endorsed organization.
- Interest rate: See the coupon rate vis-à-vis other investment opportunities to gauge its appeal.
- Tenure: Look at the period of lock-in and make sure that it fits with your financial requirements.
Key Considerations Before Investing
1. Tax Bracket Suitability
Tax-free interest bonds work best for people in the higher taxable income brackets. For a person in a lower taxable income band, the benefits associated with not paying tax on interest do not exceed other instruments in the investment spectrum.
2. Liquidity Constraints
Due to the long maturity tenure of these securities, they are illiquid. These may be sold before maturity, but the returns are not guaranteed to be satisfactory.
3. Returns vs. Inflation
Returns on tax-free bonds are stable; however, they might not be favorable regarding the inflation rate. This is something that can affect your decision-making.
4. Market Risks
All bonds including tax-exempt bonds are affected by interest rate changes in the economy, and hence the market price of the bonds may change. Increased interest rates will often result in reduced bond prices for the bonds on the secondary market.
Who Should Invest?
Tax-free securities can be suitable for:
- Individuals who earn a lot and want to control their relationship with the taxman.
- Individuals who are risk-averse and prefer a low but steady rate of return.
- Those who can plan for the long-term in advance and do not wish to convert the investments into cash in the near term.
Conclusion
Tax-exempt securities should be the choice of investors who are looking for easy-to-manage and risk-averse investments.
As a thumb rule, these securities should cater to only those individuals who fall under a higher income tax slab and who have a long-term investment objective.
You may consider these securities for addition to your portfolio after evaluating the issuer, the maturity period, and your investment objectives.
Disclaimer: This blog is meant for general knowledge and information. A financial advisor should always be consulted before you make any investment decisions.