What Is Indexation In Mutual Funds?
Before we get to the indexation in mutual funds, let us first understand what indexation means. Indexation is indexing the cost of acquisition of the asset so that it can be inflated to its current price over a certain duration.
People invest in mutual funds so that they can earn capital appreciation. Capital appreciation is the capital gains that investors realize after selling their assets or investments. Capital gains can be short term or long term depending on when the investor decides to redeem the investment. Short term capital gains have different taxation and so do long term capital gains. For equity mutual funds, taxation is different and for debt mutual funds taxation is different too.
In debt mutual funds, indexation benefit is only applicable to long term capital gains. But then again, long term capital gains have a different meaning for debt and equity. For equity mutual funds, long term capital gains are those that are redeemed by the investors are 12 months of holding whereas for debt it is those investments that are sold after 36 months.
For equity, any holdings sold within 12 months of purchase are qualified for short term capital gains tax, and for debt funds, it is applicable for investments sold within 36 months of purchase.
How is indexation calculated in mutual funds?
The Cost of Inflation Index (CII) is used to arrive at an inflation-adjusted price for indexation in mutual funds. CII index is available at incometaxindia.gov.in website.
To arrive at an inflation adjusted cost of acquisition of the debt mutual fund units, CII is divided for that year in which the fund units were sold by CII for the year in which the units were acquired and multiplied by the actual price of the units purchased.
Here’s an example to help you understand how indexation in mutual funds work. We are taking the example of debt mutual funds.
Mr. Raghavan purchased 1000 debt fund units in fiscal 2004-05 for Rs 10 and sold them for Rs 20 in the year 2009-10. Since these units were sold after five years, they qualify form long term capital gains tax with indexation benefit.
The capital gains realized will be – 1000 (20-10) = Rs 10000
First, let us calculate inflation adjusted purchase price – (632/480)*10 = 13.16
Now let’s calculate long term capital gains tax on the transaction = 1000* (Rs 20- Rs 13.6) = Rs 6400
LTCG on debt funds
The current LTCG tax on debt mutual funds is 20%. However, this is much lower than what is applicable on fixed deposits and other fixed income instruments.
Because 20% of 6400 (Rs 1280) is better than 20% of 10000 (Rs 2000). You are saving Rs 720 (2000-1280).
It is because of the indexation that investors are able to benefit from and earn better post tax returns. This makes investments in debt mutual funds a far better lucrative option as opposed to fixed income instruments that offer low interest and are taxed at a higher percentage.