Indexation in Mutual Funds

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.

Indexation Definition

Indexation is a financial technique used to adjust the value of an asset to account for inflation. By aligning the asset's value with the rate of inflation, indexation helps maintain the purchasing power of the investment over time. This adjustment ensures that the real value of the asset remains consistent, despite the increasing inflation. It is done with the help of a price index that is adjusted for inflation when an investor buys or sells a stock.

What is indexation in Mutual Funds?

Indexation adjusts the cost of a mutual fund to account for inflation when calculating capital gains. This means the gains are measured against the inflation-adjusted cost rather than the original purchase price, reducing taxable income. Capital gains taxation depends on-

- Cost Inflation Index, which is a number set by the Indian government to reflect inflation.

- The time between purchase and sale of the fund.

- Type of gains, like short-term capital gains (STCG) or long-term capital gains (LTCG).

Indexation benefits apply only to LTCG on debt mutual funds, not to equity funds or STCG. This adjustment lowers taxable gains, improves post-tax returns, and makes debt funds a tax-efficient investment choice.

How to Calculate Mutual Fund Indexation?

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

To calculate your capital gains, you need to consider the original and indexed value of the 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 the CII of 2019 was 250 and the 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 the investment is Rs. 5000 * 300/250 = Rs. 6,000.

Now, the capital gains with indexation = redemption value – the indexed value of an 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 of mutual funds.

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.

Example of Indexation Benefit in Mutual Fund

Mr. Rahul invested ₹50,000 to buy 1,000 units of a debt mutual fund scheme in 2016-17 at ₹50 per unit. In 2021-22, he sold these units at ₹80 per unit. Since the investment was held for over 36 months, Long-Term Capital Gains (LTCG) tax with indexation benefit will apply. Let's understand how:

After adjusting for inflation, Mr. Rahul gains Rs. 19,960. He'll have to pay 20% tax on this amount. Without indexation, Mr. Rahul's LTCG would have been ₹30,000, leading to a higher tax liability.

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.

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 tata capital's mutual fund app to get started today!

FAQs for mutual fund indexation

1. Is indexation applicable to mutual funds?

Yes, indexation is applicable to mutual funds. It allows investors to adjust the value of their long-term investments for inflation, reducing the taxable capital gains.

2. How do I calculate indexation?

You can calculate indexation by identifying the Cost Inflation Index (CII) for the year of purchase and the year of sale. Then, calculate the indexed cost of acquisition and subtract it from the selling price to determine the inflation-adjusted capital gains.

3. How to calculate the indexation value?

To calculate the indexation value, divide the CII for the year of sale by the CII of the year of purchase and multiply it by the original cost of acquisition.

4. What is the current indexation rate?

The current indexation rate for the financial year 2023-24 is 348.

5. Which assets are eligible for indexation?

Indexation applies to long-term capital assets like debt funds held for over three years and certain physical assets. It helps adjust the asset's purchase price for inflation, reducing taxable gains.

6. What is indexation in simple words?

Indexation adjusts the purchase price of assets based on inflation, lowering taxable gains. It helps maintain the asset's real value over time, ensuring investors pay tax on actual profits rather than inflation-driven increases.