Tax on fixed income

Everything in this subject so far has been about pre-tax numbers. The coupon, the yield to maturity, the spread — all of them are quoted before the government takes its share, and for fixed income that share is larger than for anything else an individual owns.

A note on scope. Rates, thresholds and the treatment of particular instruments change with each Finance Act, and this site does not restate numbers it cannot cite. What follows is the structure, which is durable; the Tax subject covers the current rules, and the Income Tax Department's own pages are the authority for any figure you are about to act on.

Interest is ordinary income

The classification is the whole chapter. Interest other than interest on securities is taxable under the head "Income from Other Sources", and tax is deducted at source on such interest paid to a resident under section 194A.

"Income from other sources" means it joins your salary and is taxed at your slab rate. There is no special rate, no concessional treatment, and no distinction for having held it a long time.

Compare that with the shape of equity taxation, where gains are taxed under their own regime with rates that depend on how long you held. The details differ by year; the asymmetry does not. Fixed income is taxed less favourably than equity, consistently, and that is a structural feature of the system rather than an accident of a particular budget.

What this does to the comparison

Here is why it matters more than it sounds.

A bond yielding 7.5% and an equity portfolio expected to return 11% look like a 3.5 point gap before tax. After tax, at a high marginal rate, the bond's 7.5% might be nearer 5%, while the equity return is reduced by considerably less. The gap widens, sometimes by half as much again.

Two consequences follow, and they pull in opposite directions.

Fixed income is a worse long-term compounding vehicle than its headline suggests. For money that will sit for twenty years, the tax drag on interest compounds against you exactly as the expense ratio did in chapter 10 of the mutual funds subject.

It does not stop being the right asset for short-horizon money. Chapter 3 established that a bond matched to your horizon has no price risk. Paying tax on a certain 7.5% is a better outcome than taking equity risk with money you need in two years. Tax changes the size of the advantage; it does not change which asset suits which job.

TDS is not the tax

The most common confusion, and it costs people money in both directions.

Tax deducted at source is an advance against your liability, not the liability itself. Two things follow.

If your slab rate is above the TDS rate, you owe more. The deduction was partial, and the balance is due when you file. People who treat TDS as settlement get a demand later.

If your total income is below the taxable threshold, the TDS is refundable — and there are declaration forms that stop it being deducted in the first place for those eligible. Money deducted and never reclaimed is a real, common and entirely avoidable loss.

TDS also has thresholds below which nothing is deducted, with different limits for banks, co-operative societies and post offices, and separate treatment for senior citizens. Those are exactly the numbers that move, so check them rather than remember them.

Interest is taxed when it accrues, not when you see it

A subtlety that catches holders of cumulative instruments.

If an instrument pays everything at the end — a cumulative deposit, a zero coupon bond of chapter 2 — interest is generally taxable as it accrues each year, not in the final year when the money arrives. So you can owe tax on income you have not yet received.

This is not a trap so much as a cash flow fact, and it argues for knowing which of your holdings accrue and which pay.

Three practical habits

Quote yourself the after-tax yield. A 7.5% bond at a 30% marginal rate is a 5.25% bond for you. That is the number to compare against other opportunities, and against inflation in chapter 11. Comparing pre-tax yields across instruments with different tax treatments is comparing nothing.

Put the right assets in the right place. If you have both a taxable account and tax-advantaged vehicles, interest-bearing assets suffer most from being in the taxable one. This is a genuinely free improvement available to anyone holding both.

Check the rules for the specific instrument before you buy. Deposits, government securities, corporate bonds, debt funds and small savings schemes do not all receive identical treatment, and the differences have been changed by Finance Acts more than once. The instrument's own documentation and the Income Tax Department are the authorities.

The point

Interest is taxed as income from other sources at your slab rate — the least favourable treatment in the system — so the after-tax yield is the only fixed income number worth comparing. TDS is an advance rather than the final tax, refundable if too much was taken. Rates and thresholds change, so verify before acting.