Indexation plays an important role while investing in debt funds. It helps to reduce your overall tax liability by adjusting the purchase price of the underlying instrument.
The article covers the following aspects about indexation:
1. What Is Indexation?
Worried about losing your debt fund returns to the taxman?
Stop worrying, start indexation!
Indexation is a prudent way to prevent draining of your debt fund returns by way of taxes. It helps you to inflate the purchase price of the debt mutual funds. In this way you can lower your tax liability.
Before embarking on indexation, it’s important for you to understand two concepts i.e. inflation and capital gains.
Inflation is the gradual increase in the price of a product or service. What is worth ₹100 today will be worth ₹200 or more next year; and even more than that the year after. In this way, inflation adversely affects your purchasing power.
It means for the same amount of money, you will be able to buy fewer things year after year as compared to what you can buy today. The cost of a product or service will go from ₹100 to ₹110 because of inflation, but its value will remain the same.
2. How are capital gains treated in Mutual Funds?
Now, let’s have a look at capital gains.
Capital Gains refer to an increase in the value of an investment over a specific time frame. If the NAV of your debt fund was Rs 10 last year and today it stands at Rs 15, your investment has experienced a capital gain.
In other words, capital gains is the difference in the purchase price and current market price of an investment. In case of debt funds, you make long term capital gains when your holding period is more than 36 months.
Unlike equity funds, long term capital gains on debt funds are taxable at the rate of 20% with the benefit of indexation. You need to know that the concept of indexation is not applicable in case of equity funds.
3. What are the benefits of Indexation?
Indexation is used to adjust the purchase price of a debt fund so as to reflect the effect of inflation on it. A higher purchase price means lesser profit, which effectively means lesser tax.
By applying indexation, you can actually reduce your long-term capital gains to lower your taxable income. It’s due to this reason that debt funds are regarded as superior fixed-income investments than fixed deposits (FDs).
Thus, in this way indexation makes the game of investment a win-win affair.
The rate of inflation used for indexation can be taken from the government’s Cost Inflation Index (CII). The values in the index are determined by the Central Government and updated on the Income Tax Department’s website. You can view the Cost Inflation Index from 1981 onwards.
4. How does Indexation work in Debt Funds?
Gains from the sale of debt mutual fund units are classified as capital gains, which allows the investor to use indexation while computing tax on them. This is applicable on long-term capital gains on investments that have been held for 3 years and more.
Let’s say you invested in a debt fund in May 2014. Your investment amount was ₹10,000 and you bought the units at an NAV of ₹10. Three years later, you redeemed your investments in June 2017 at an NAV of ₹20.
Hence, when you sold your investments, the value of your investments was ₹20,000. Your investment made capital gains worth ₹10,000. However, you need not pay tax on this entire amount of ₹10,000.
As your holding period was 3 years, you will get the benefit of indexation to reduce the value of your long-term capital gains.
To arrive at the Indexed Cost of Acquisition (ICoA), you have to use the following formula:
ICoA = Original cost of acquisition * (CII of year of sale/CII of year of purchase)
In the above example, the indexed cost of acquisition will be 11,980 (10,000 * 1125/939). Hence, instead of ₹10,000, your capital gains will now be ₹8,020 (₹20,000 – ₹11,980).
Using indexation, you managed to not pay tax on nearly ₹2,000 of your gains. Your tax will be computed on only ₹8,020, which will be equal to ₹1,604.
The benefit of indexation works best when your holding period is longer. For a holding period of 5 years, long-term capital gains tax on debt funds can come down from 20% to 6-7%.
This is how indexation helps you to save tax on gains from debt mutual funds and enhance your earnings.
