Bond taxation isn't more complicated than FD taxation but it does offer a few more levers that can affect your post-tax return. For many investors, the biggest tax advantage of bonds isn't lower tax on interest, it's the possibility of having part of the return taxed as capital gains instead of ordinary income.
The two sources of bond income
Bonds generate returns in two ways, and each is taxed differently: interest income (the regular coupon payment) and capital gains (the difference between the price you paid and the price at which you sell, or the face value received at maturity).
How interest income is taxed
Interest is taxed at your income tax slab rate, exactly like FD interest, with no special tax concession. The issuer deducts Tax Deducted at Source (TDS) at 10% before interest reaches your account. If you're due INR 1,000, INR 900 lands in your bank account, while INR 100 is reflected in Form 26AS and can be claimed as a credit against your final tax liability. If your income is below the basic taxable threshold, you may submit Form 15G (or Form 15H for senior citizens) to avoid TDS being deducted at source.
How capital gains are taxed
This is where bonds become more interesting than FDs, because FDs generally do not provide the opportunity to generate capital gains. If a bond is held for more than 12 months, any gain is treated as a Long-Term Capital Gain (LTCG) and taxed at a flat 12.5%, regardless of your income-tax slab. For investors in higher tax brackets, this can be significantly lower than the tax paid on FD interest. If the bond is held for 12 months or less, any gain is treated as a Short-Term Capital Gain (STCG) and taxed at your applicable income-tax slab rate. Capital losses from bonds can also be set off against eligible capital gains, something that is not possible with FD interest income.
No TDS on capital gains
Unlike interest income, capital gains are generally credited without any TDS deduction. The full gain is received upfront, and any applicable tax is paid when you file your income-tax return. This is one reason a bond's quoted yield can differ from the cash arriving in your bank account each year: part of the return may come from capital gains, which are realised later rather than paid periodically.
Reporting bond income in your ITR
- Interest income → reported under “Income from Other Sources”.
- Capital gains (if any) → reported under the “Capital Gains” schedule, along with the purchase and sale details.
Two ways bonds can actively save you tax
Certain public-sector undertaking (PSU) bonds pay interest that is fully exempt from income tax, a benefit that conventional FDs do not offer. If you sell before maturity, any capital gain remains taxable, but the interest already received remains tax-free.
54EC capital gains bonds: investors who have realised long-term capital gains from the sale of property can reinvest those gains, subject to applicable limits, into 54EC bonds and claim an exemption from the associated capital-gains tax. These bonds carry a mandatory five-year lock-in period, and the interest earned on them remains taxable at your income-tax slab rate. While the coupon is typically modest, the tax saved on property transactions can be substantial.
A quick worked example
Suppose you earn INR 8,000 in interest income and INR 5,000 in long-term capital gains during your holding period. If you're in the 30% tax bracket, the interest income results in INR 2,400 of tax (with INR 800 already deducted as TDS). The long-term capital gain is taxed at 12.5%, resulting in INR 625 of tax. Your total tax bill is therefore INR 3,025. By comparison, if the entire INR 13,000 had been earned as FD interest, the tax at a 30% slab rate would be INR 3,900. The difference comes purely from how the two instruments are taxed, not from taking on additional risk or changing your investment strategy.
This article is for general information only and isn't tax advice. Please consult a qualified tax advisor for guidance specific to your situation.