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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.<\/p>\n\n\n\n
Luckily, there\u2019s a special rule called indexation to ease your pains. Let\u2019s explore how.<\/p>\n\n\n\n
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Now you must be wondering about the indexation meaning.<\/p>\n\n\n\n
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.<\/p>\n\n\n\n
All capital gains are taxed using the following factors \u2013<\/p>\n\n\n\n
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.<\/p>\n\n\n\n
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.<\/p>\n\n\n\n
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.<\/p>\n\n\n\n
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Since it is already clear that there are no indexation benefits on equity mutual funds, lets\u2019 look at some excellent indexation benefits on debt funds that investors enjoy.<\/p>\n\n\n\n
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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).<\/p>\n\n\n\n
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.<\/p>\n\n\n\n
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Here is a tabular representation of how a debt fund is taxed in India.<\/p>\n\n\n\n To calculate your capital gains, you need to consider the original and indexed value of the investment of the fund.<\/p>\n\n\n\n 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 \u2013 5000) on the fund sale.<\/p>\n\n\n\n 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\u2019s purchase price. And adjust the inflationary changes in the capital gains to reduce your tax liability. Here\u2019s how.<\/p>\n\n\n\n For the sake of explanation, let\u2019s say CII of 2019 was 250 and CII of 2022 was 300.<\/p>\n\n\n\n Original value of investment = Rs. 5000<\/p>\n\n\n\n Indexed value of investment = invested amount * CII of redemption year\/CII of the purchase year<\/p>\n\n\n\n So, here, the indexed value of investment is Rs. 5000 * 300\/250 = Rs. 6,000.<\/p>\n\n\n\n Now, the capital gains with indexation = redemption value \u2013 indexed value of investment<\/p>\n\n\n\n That is, 10,000-6,000 = 4,000<\/p>\n\n\n\n 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\u2019ll 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.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n <\/p>\n\n\n\n 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<\/a> to get started today!<\/p>\n\n\n\nParticulars<\/td> Scenario A<\/td> Scenario B<\/td><\/tr> Holding Period<\/td> Less than 3 years<\/td> More than 3 years<\/td><\/tr> Type of Gains<\/td> STCG<\/td> LTCG<\/td><\/tr> Tax Liability<\/td> Taxed at regular rates<\/td> Taxed at 20% minus indexation benefit<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n Conclusion<\/strong><\/h3>\n\n\n\n