Inflation is a funny phenomenon for investors. Because when the rate of inflation increases, so do the profits from your investments. But the catch is, there are no capital gains without the tax pains. And profits from your mutual funds are no different.

Luckily, there’s a special rule called indexation to ease your pains. Let’s explore how.

What is indexation in mutual funds?

Indexation means adjusting the cost of a fund by accommodating the inflationary price changes in the redemption cost. Such that, the gains are calculated against the current price of the fund, and not the price at which the fund was purchased.

All capital gains are taxed using the following factors –

  • Cost of inflation index (CII): A number the Indian governmentissues to represent the year’s inflation rate.
  • Holding period: The period between the purchase and redemption of an asset.
  • Types of gains: Returns from any investment with a holding period of less than 3 years are called short term capital gains (STCG). And long term capital gains (LTCG) for a period of longer than 3 years.

Indexation benefits, however, doesn’t apply to equity funds and neither to STCG. Only LTCG on debt funds are eligible for indexation.

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How to calculate mutual fund indexation?

Here is a tabular representation of how a debt fund is taxed in India.

  Particulars   Scenario A  Scenario B
  Holding Period  Less than 3 years  More than 3 years
  Type of Gains  STCG  LTCG
  Tax liability   Taxed at regular ratesTaxed at 20% minus indexation benefit

To calculate your capital gains, you need to consider the original and indexed value of investment of the fund. 

Suppose you invested Rs. 5000 in a debt fund in 2018 and redeemed the fund after 3 years at Rs. 200 NAV in 2021. So you earned a return of Rs. 5000 (10000 – 5000) on the fund sale.

Now, since your holding period was three years, you can avail of the indexation benefit by considering the indexed value of the investment as the fund’s purchase price. And adjust the inflationary changes in the capital gains to reduce your tax liability. Here’s how.

For the sake of explanation, let’s say CII of 2018 was 250 and CII of 2021 was 300.

Original value of investment = Rs. 5000

Indexed value of investment = invested amount * CII of redemption year/CII of the purchase year

So, here, the indexed value of investment is Rs. 5000 * 300/250 = Rs. 6,000.

Now, the capital gains with indexation = redemption value – indexed value of investment

That is, 10,000-6,000 = 4,000

So, your taxable income now comes down to Rs. 4,000 as opposed to Rs. 5000. And as per the applicable rate of 20%, you’ll be charged Rs. 800 as tax. Now, imagine if the holding period were five years or ten years, the tax rate would have come down even further. 

So, essentially, the longer the holding period, the more tax you can save on the inflationary gains. This is the indexation benefit on mutual fund.

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As you can see from the above example, indexation can bring down your taxable income by a profitable margin. Are you also thinking of investing in debt funds? Download the Moneyfy app to get started today!

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