How much tax do infra bonds really save?

The IDFC Infrastructure Bonds issue joins five other issues this financial year. A similar issue by Rural Electrification Corporation is already open. By investing in these products, taxpayers can claim a deduction of up to Rs 20,000 under Section 80CCF. This is above the Rs 1 lakh invested under Section 80C. While you save tax, your real returns may not be as high or precise as those being projected by some brokers. So before you rush to invest in the issue, here are a few points to ponder.

Good for saving tax:

IDFC bonds have a tenure of ten years and offer 8% interest on both the annual payout and cumulative options. The effective rate of return rises if you account for tax savings. The higher the tax bracket, the more the tax-saving potential. That means taxpayers in the 30% tax bracket will earn marginally higher returns than those falling in the 10% tax bracket.

If the company buys back the bonds after the lock-in of five years, the effective return would be 12.1%. This is higher than what most fixed income instruments will offer.

Don’t believe in projections:

Your broker might try to lure you with calculations that show spectacular returns of up to 17-18% in case of a buyback of the bonds by the company after five years. Such a high rate looks probable only because there is a flaw in the assumptions. But the real rate of return is revealed when you crunch the numbers. First, to project high returns, it is taken for granted that the investor falls in the top tax bracket.

Now, considering tax savings of Rs 6,180 (30.9% of Rs 20,000), the actual investment drops to Rs 13,820 (Rs 20,000–Rs 6,180). The rate of return on this (using the concept of internal rate of return), considering the 8% earned every year for 5 years and the buyback at Rs 20,000, works out to about 18%. The problem with this figure, however, is that it assumes that the interest earned is tax-free, which is not the case. It also assumes that the interest earned every year is reinvested at 18% for the remaining tenure.

Also, the interest further earned on the reinvested amount is assumed to be tax-free, which again is incorrect. When accounted for all this, the effective return declines to about 12% —assuming that the interest is reinvested at 8% and the interest earned on the reinvested amount is taxed at 30.9%.

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