When you invest in a mutual fund, you usually calculate the inherent risks and estimate the returns and accordingly decide whether the investment is worth the risk involved. Generally, risk and return are directly proportionate, i.e., higher the risk on a particular investment, higher will be your returns. Such returns are subject to capital gains tax which effectively reduce your overall gains from an investment. However, through indexation, you can mitigate the negative impact of capital gains tax on your investment returns. Indexation plays a major role in reducing the overall tax liability by regulating the purchase price of the investment being indexed. It is important to note that the indexation benefit is applicable to long-term debt investments.
Concept of Indexation
You must have definitely noticed that over a period of time the cost of buying things increases. A toothbrush that cost you approximately Rs. 20 in 1990 might now cost you Rs. 35. This increase in the price of the toothbrush is known as inflation. The government calculates the prices of all essentials and creates a cost-of-living index. As prices increase, so does the value of the cost-of-living index. Indexation is a method which ensures that the wages paid and the interest rates in the economy are linked to this cost-of-living index and reflect the increase in prices of essential goods. Similarly, indexation also ensures that the price of your investment gets adjusted for inflation.
Under the current income tax rules, your investments are subject to capital gains tax.
- Short-term capital gains tax: Applicable to equity investments sold within one year of purchase and debt investments sold within three years of purchase
- Long-term capital gains tax: Applicable to equity investments sold after one year of purchase and debt investments sold after three years of purchase
The concept of indexation can help you reduce the impact of capital gains tax on your long-term debt investments. As indexation is tied to inflation, it helps to track the gain or loss made on an investment. The tool permits income tax payments to be adjusted through a price index, enabling investors to maintain their purchasing power after factoring in inflation. The technique also helps to prevent the drain of investment returns by lowering the liable tax.
Calculations that you should know
Capital gains refers to the profits made on your investment over a specific period of time. Let’s take an example to understand capital gains better.
This profit or increase in the value of your investment is referred to as capital gains. Simply put, capital gain is the difference between the purchase price and the sale price of your investment. If you redeem your investment in a debt mutual fund within three years of purchase, then the returns would be added to your income and taxed as per the applicable income tax slab. However, if you redeem the investments after three years, returns would be taxed at 20% with indexation benefit. What indexation does is that it increases the cost of purchasing the investment to reflect the prevailing rate of inflation. The rate of inflation to be used for indexation can be obtained from the government's Cost Inflation Index (CII), available on the website of the income tax department.
For example, the long-term capital gain in the above example is Rs. 50,000. However, the cost of purchase needs to be indexed to reflect the current cost of purchasing the same investment. The CII for the year 2017-18 was 272 while the CII for the year 2020-21 is 301. The formula for calculating the current cost of this investment is:
Indexed Cost of Acquisition = (CII in the year of sale / CII in the year of purchase) * cost of purchase
= (310 / 272) * 100000 = Rs. 113970
Now, for the purpose of calculating long-term capital gains, we will assume Rs. 1,13,970 as the purchase price
Long-term capital gain without indexation
Long-term capital gains with indexation
Due to indexation, the tax liability has reduced from Rs. 10,000 to Rs. 7,206.
Please note: The capital gains are reduced only for the purpose of calculating tax. The actual gains to the customer will be Rs. 50,000.
Benefits of Indexation
Indexation is considered as one of the most structured and trustworthy provisions forsaving tax on long-term debt investments. The technique enables investors to raise the purchase price of the asset, in tandem with inflation. It offers two major benefits to investors:
- Lowers the capital gains value for the purpose of calculating capital gains tax, thereby lowering the overall tax liability
- Mitigate the impact of inflation on investment returns
With such benefits, indexation can offer you a better chance to make a good profit even after paying the capital gains tax.
Simple tools like indexation can help you reap maximum gains from your investments. From that perspective, long-terminvestments in debt mutual funds can help you generate optimal tax-adjusted returns.
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MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
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MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
