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?

Now you must be wondering about the indexation meaning.

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 government issues 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.

As far as its benefits are concerned, there are no indexation benefits on equity mutual funds and neither to STCG. Only LTCG on debt funds is eligible for indexation.

Investing in debt mutual funds is a profitable option due to indexation as it gives an opportunity to the investors to earn handsome post-tax returns.

But how? With the help of indexation, your long-term capital gains will be lower which ultimately brings down the taxable income. Hence, indexation makes investment in debt funds much easier and more lucrative when compared to other investment options.

Benefits of Indexation

Since it is already clear that there are no indexation benefits on equity mutual funds, lets’ look at some excellent indexation benefits on debt funds that investors enjoy.

  • Indexation benefits on debt funds allow investors to earn high profits as the tax liability is low. It further encourages people to make investments in mutual funds.
  • It also gives the opportunity to investors to increase an asset’s purchase price. It helps lower the risk of the cost that can be caused by inflation.
  • Indexation meaning in debt funds equals high returns on investments. It allows only the tax on LTCG gains to be adjusted, without impacting the absolute gains.
  • When compared to other investment options like fixed deposits, indexation in mutual funds brings stability as it reduces LTCG liability for investors, making it a much more attractive investment option.

Taxation of debt funds

As per the government rules, if an investor sells an asset after 3 years from the date of its purchase, then the gains will qualify as Long-Term Capital Gains (LTCG) which will be taxed at 20% after applying the concept of indexation. On the other hand, if an investor sells an asset in less than 3 years, the gains they will earn are Short-term Capital Gains (STCG).

The indexation in mutual funds is only applicable to LTCG on debt funds to reduce the tax liability of the investors and further, to yield higher returns.

How to calculate mutual fund indexation?

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

ParticularsScenario AScenario B
Holding PeriodLess than 3 yearsMore than 3 years
Type of GainsSTCGLTCG
Tax LiabilityTaxed 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 2019 and redeemed the fund after 3 years at Rs. 200 NAV in 2022. 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 2019 was 250 and CII of 2022 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.

Conclusion

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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