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Indexation Benefit in Mutual funds & its Importance on Returns

Interested in learning more about mutual fund indexation? Find out more about mutual fund indexation, its importance, benefits, and how it is calculated by reading this article.

While investing in mutual funds for the long term helps you gain a large corpus, there are also tax implications that investors can't avoid. Employing specific strategies can help you save your returns from draining away due to tax. Here we are talking about one of those, which is indexation in mutual funds. Indexation has a crucial role in determining gain and loss on your investments. 

What is indexation in mutual funds? 

Indexation is a process by which investors can carry out their returns fairly by factoring in inflation. It is one of the known concepts that investors apply for calculating returns. 

Indexation applies to long-term investment in debt mutual funds and other asset classes, excluding equity funds. It helps investors adjust the purchase price of their investment in line with the inflation price to lower tax liability on returns. To execute indexation in mutual funds, investors have to consider two aspects: inflation and capital gains. 

When an investor exits their long-term debt investment or redeems the units held for three years or more, the capital gains generated from the same are adjusted, as per the inflation rate, referred to as indexation benefit. 

How are capital gains from mutual funds calculated with indexation?

Capital gains are basically the difference between your purchase price and the sale price of mutual fund units. Long-term capital gains from debt funds get taxed at 20%. Along with this comes the indexation benefit on the mutual funds. Indexation here plays a crucial role in how much capital gain you earn from your mutual funds, and taxes get added to it. The more you gain from the funds, the more tax you have to pay. In the case of inflation, tax imposition further increases. So if you have invested in debt funds for 3 or more years, you must utilize the indexation benefit and maximize your returns by minimizing taxation on them. 

Consider, during the purchase of fund units, the NAV is Rs 12. After 3 years, it has increased to Rs 15, so the capital gains from this are Rs 3. However, when considering inflation, your capital gains must be in line with the inflation rate & taxed accordingly. 

To calculate the capital gains with indexation, you can follow the following steps.

First, you need to calculate the current inflation price, called the Indexation cost of acquisition, using the following formula.

*Consider you have invested in duration between 2019-2022. For this, the Cost Inflation Index (CII) is 289 and 317, respectively. (The rate of inflation is gets updated by the government on the income tax department website) 

Indexation cost of acquisition = Original cost of acquisition x (CII of the year of sale/CII of year of purchase)

= 12 x (317/289)

= 13.16

The capital gains for taxation will be calculated as 

= sale price (redemption price) - indexation cost of acquisition. 

= 15- 13.16

= 1.84

The tax rate on long-term capital gains from debt funds is 20%. So, in this case, you would need to pay 1.84 x 20% = Rs 0.36 as tax. On capital gain of 15-12 = 3, the tax is 0.36. 

What are the benefits of indexation? 

There are some excellent indexation benefits on mutual funds that investors can enjoy when they invest in debt funds for the long term. 

  • With indexation, investors get the opportunity to increase their assets' purchase price in line with the inflation rate, which removes the risk of losing the purchasing power of money caused by inflation. 
  • Indexation benefits encourage more people to invest in mutual funds as it allows them to earn more returns by reducing the tax implications. 
  • Implementing the indexation in mutual funds while assessing gain and loss on investments helps investors to accumulate more returns in their accounts. With Indexation tax on long-term capital gains (LTCG) can be easily adjusted without impacting actual capital gains. 
  • As compared to other investment options, such as bank FDs, which attract TDS, having indexation benefits on mutual funds is a better option. With a mutual fund, you can earn higher returns and save more tax on long-term gains through indexation. 

How does indexation work in debt funds?

Let's understand the working of mutual fund indexation through an example. Suppose you have invested in a debt fund scheme in 2019. In this case, you have bought fund units at a NAV of Rs 20 at an investment amount of Rs 20,000. After three years (year 2022), you redeem fund units at a NAV of Rs 30. Your investment value has now become Rs 30,000, whereas your capital gains stand at Rs 10,000. But, since your holding period is three years, your returns will be considered long-term capital gains and have the indexation benefit. With indexation, you can reduce the value of your gains and get taxation benefits. 

*Consider CII for financial 2019-20 is 289, and that of FY 21-22 is 317. 

So your purchase cost can be indexed up as (Indexation cost of acquisition)

= Current inflation price or Indexation cost of acquisition x (CII of the year of sale/CII of year of purchase)

= 20 x (317/289)

Indexation cost of acquisition = Rs 21.93

The capital gains for taxation will be calculated as 

= sale price (redemption price) - indexation cost of acquisition. 

= 30 - 21.93

= 8.07

The tax rate on long-term capital gains from debt funds is 20%. So in this case, you would need to pay 8.07 x 20% = Rs 1.61 as tax. On capital gain of 30-20 = 10, the tax is 1.61. 

The indexation benefits are even more noticeable for long holding periods. For a holding period of 5-6 years, you can reduce tax on returns from 20% to even 5-6%. For interest in bonds, a marginal slab rate of 30% is applicable, and the same for the short-term gains. 

How does indexation work in mutual funds?

The indexation benefit is mainly available for debt mutual funds (long-term capital gains) along with other asset classes such as real estate, gold, stocks and shares of a listed or an unlisted company, & more. However, in the case of debt funds, you need to hold your units for 3 and more years to earn long-term capital gains. For the short term, there is no indexation benefit on mutual funds. In the case of long-term capital gains, a 20% tax rate is applicable after utilizing the indexation benefit. 

Indexation for equity funds has not been made available yet. So the gains earned from these funds will get taxed at a flat 10%. In the case of hybrid funds, they have both equity and debt funds elements. So if the hybrid fund scheme holds more than 65% debt funds, it will be considered a debt fund. Here the indexation benefit will be applicable.

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