Inflation tends to rise with each passing year and impacts your investment returns. However, one way you can reduce its impact is by using indexation on your investments.
Indexation is a technique that allows the purchase price of an investment to be adjusted to account for inflation.
Indexation is necessary for protecting your investments’ real value against inflation, especially when it comes to Mutual funds.
In this article, we will learn more about what is indexation in mutual funds and its benefits.
What is Indexation in Mutual Funds?
Whenever you make a redemption or any sale in mutual funds, it generates capital gains. Depending on the length of the holding period, capital gains can be either long-term or short-term.
You can avail of the indexation benefits only if you invest in long-term debt mutual funds. This benefit is not available for equity mutual funds. You can use indexation for debt funds.
For debt funds, a holding duration of 36 months or longer is regarded as long-term. And, if the duration is less than 36 months, it is treated as short-term.
Indexation helps in determining the current worth of your investment while taking into account inflation and assists in getting actual capital gains. However, from April 1, 2023, debt funds are no longer eligible for the LTCG advantage.
Take the example of an investor who paid Rs 100,000 to purchase units of a debt mutual fund in 2016 and sold them for Rs 150,000 in 2024. Here, the capital gain would be Rs. 50,000. The purchase price may, however, change to Rs 120,000 when indexation is applied, bringing the taxable gain down to Rs 30,000. This adjustment helps to minimize the tax liability due to the benefit of indexation.
Benefits of Indexation in Mutual Funds
Here are some main benefits of indexation in mutual funds investment:
Reduced Tax Obligation
Thanks to indexation, you can now adjust the purchase price of your investments for inflation. Taxable capital gains are reduced by applying the indexed cost of acquisition, which lowers the tax obligation.
Protection Against Inflation
Indexation modifies an investment’s initial cost to prevent inflation from eating away at its value.
Promotes Long-Term Investment
By offering tax relief, indexation encourages you to hold onto your investment for a longer period, which contributes to the long-term accumulation of wealth.
Fair Tax Structure
Indexation accounts for real gains that have been adjusted for inflation, which contributes to a more equitable tax structure.
Setting off Losses
Debt funds enable you to lower your taxable income and obligations by offsetting your losses against the profits.
How is Indexation Calculated?
Every financial year, the Central Government declares the Cost Inflation Index (CII), which is used to calculate indexation on capital gains. The rate of taxation on capital gains will be determined by the investor’s income tax slab.
Indexed Purchase Price = Actual Cost of Acquisition x (CII of the year of sale / CII of the year of purchase)
Here, the Cost Inflation Index (CII) is an indicator of inflation used to determine long-term capital gains for tax purposes. CII is updated every year on the website of the Income tax department. You need to be aware of this method in order to calculate your taxes and capital gains accurately.
Taxation on Debt Funds After the Budget 2023
Some changes introduced in the Budget 2023 indicate that the indexation benefit for Specified Mutual Funds will no longer apply for calculating long-term capital gains (LTCG).The relevant slab rates will therefore now apply to debt mutual funds.
Schemes, where equity investments make up less than 35% of the entire portfolio, will not be eligible for the indexation advantage.
It will be regarded as short-term capital gains regardless of your holding period. For investments made on or after April 1, 2023, this will be applicable.
Also, apart from equity and debt, there’s another category that has been introduced. Here are all the categories:
Equity Oriented Fund- Fund schemes that have at least 65% of their portfolio in equity shares.
Specified Mutual Fund- A maximum of 35% of the portfolio is made up of equity shares.
Other Mutual Funds- Schemes with exposure to more than 35% but less than 65% of equity shares. These are eligible for the indexation benefit if the holding period is more than 36 months.
Conclusion
Indexation is an essential concept, especially when it comes to long-term capital gains on mutual funds.
It provides an adequate and precise way to account for inflation when determining an asset’s purchase price, which lowers taxable capital gains.
However, to receive indexation benefits, you need to be cautious about selecting the right mutual fund as there have been changes in indexation post Budget 2024. So, do your research and invest your money wisely.
