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WHAT IS INDEXATION IN MUTUAL FUNDS: MEANING AND BENEFITS

Getting a good return is one of the main factors to consider while making a long-term investment, which defines the gain or loss of any investment. But very often, while considering these returns, people do not factor in their tax liabilities with regards to the gains earned from these investments, which has a big impact. In a true sense, it is the post-tax returns that actually matter, and indexation is one way through which investors ensure they pay lower tax on their capital gains.

Indexation in mutual funds is a popular concept when it comes to investing and long-term capital gains. Debt funds indexation plays an important role in determining if the investments will generate good returns, as well as to find out the total tax on such investments. It helps investors bring down the taxes they pay on their debt mutual fund investments, essentially lowering their losses and increasing the profits.

What is Indexation in Mutual Funds?

Indexation in mutual funds is a concept that refers to recalculating the purchase price of an asset, so as to prevent capital gain tax. The Income Tax authority allows for the cost of the asset at which it is purchased to be indexed, i.e. adjusted or inflated, over a period of time as per its current value after taking inflation into consideration. This essentially adjusts the purchase price of the asset to an increased value; hence the capital gain gets reduced and investors get tax benefit on the profits.

Mutual funds indexation is applicable on long-term investments, including debt funds and other asset classes, that lowers the tax liability of a person by utilizing the concept of inflation, leading to indexation benefit on mutual funds.

Why is indexation in mutual funds important?

As defined by the government, if an investor sells the asset after 36 months from the date of purchase, the gains or the profits earned from that transaction qualify as long-term capital gains, or LTCG. But if an investor sells that asset in less than 3 years, then the gains earned are termed as short-term capital gains, STCG. The concept of indexation in mutual funds is applicable to the taxation of debt funds or debt-oriented mutual fund schemes rather than on conceiving indexation benefit on equity mutual funds, to reduce the investor’s tax liability on LTCG and to ensure higher returns.

How does it work?

Indexation benefit on debt mutual funds is calculated using the Cost of Inflation Index, or CII, which is a key factor to artificially inflate the purchase price of the asset so that it reflects its true value in the year of taxation.

To find the actual or the indexed price of the asset, the purchase price is multiplied by the CII for that year, divided by the CII for the purchase year. The value thus obtained is considered as the inflation-adjusted purchase price, and can be deducted from the selling price to obtain capital gains. Tax liability on long term capital gains (LTCG) applicable is then calculated at 20% + surcharge, with indexation and 10% + surcharge, without indexation.

The government makes the CII available for each year at incometaxindia.gov.in for reference.

An Example

Let us try and understand the concept of debt funds indexation with the help of an example.

A person buys an asset in the FY 2009-2010 for ₹3 lakhs and sells it in FY 2016-2017 for ₹6 lakhs. If that person were to pay taxes on the gains earned without indexation, then taxable amount = ₹6 lakh - ₹3 lakh = ₹3 lakh. And capital gains tax = 10% (₹3 lakh) = ₹30,000.

Now, let’s say that person wants to apply indexation to his investment.

CII for FY 2009-2010 = 148

CII for FY 2016-2017 = 264

So, indexed purchase price = (3X264)/148

                                             = ₹5.35 lakh

Capital gains = ₹6 lakh - ₹5.35 lakh = ₹65,000; and capital gains tax = 20%(₹65,000) = ₹13,000.

Thus, with indexation, the person saved more than half of the tax liability on the exact same investment with similar returns.

Benefits of Indexation

These are some of the benefits of indexation in mutual funds that investors enjoy.

  • Indexation benefits on debt funds reduce the tax liability of investors, ensuring higher profits and in turn encouraging increased investments.

  • The concept of indexation provides investors with an opportunity to increase the purchase price of the asset, which helps reduce the adverse impact on the cost caused by inflation.

  • Indexation ensures investments yield high returns for investors, as it is only the tax on LTCG gains that is adjusted and reduced and not the absolute gains that are impacted.

  • The concept allows investors to earn a handsome profit even post-tax deductions, hence lowering their taxable income.

  • Indexation in mutual funds further brings stability and provides liquidity, which makes mutual funds a more attractive investment instrument for investors as compared to conventional fixed deposits.

Indexation in mutual funds is a powerful tool that can be utilized to save tax and reduce one’s long term capital gain liability. The tool is especially effective on debt funds indexation, reducing the taxable gains that take a toll on the returns from these investment.

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