Indexation in mutual funds

Terms like indexation adjusted returns, indexation benefits etc. are very common in mutual funds since indexation is used to cushion the returns against inflation and taxes. Before moving to the concept of indexation, let us first read about inflation and capital gains.

Inflation means consistent increase in the price levels of a basket of goods over a period. This would simply mean that purchasing power is curtailed since people would be able to buy less with the same amount of money they used to buy earlier. Inflation has same impact on savings and financial goals as it eats up the large chunk of savings therefore leaving less amount to invest. The returns on investment will be lesser in times of inflation if indexation benefits are not availed.

If you want to learn more about inflation and its impact on your returns please read our blog on the same by clicking the link: https://www.sipfund.com/blog/Impact-of-inflation-on-mutual-funds.html

On the other hand, capital gains in mutual funds refer to the appreciation in investments over a period. It is simply the difference between the NAV at the time of purchase and NAV at the time of redemptions.

For example, suppose the NAV of a debt fund was ₹ 15 at the time of purchase and today the NAV is at ₹ 20, the value of investment has increased, and this is exactly called the capital gains on investments. In this case, a capital gain of ₹ 5 will be availed on per unit of mutual fund at the time of redemption.

So, what is Indexation?

Indexation is a method through which we can adjust or inflate (index) the cost of acquisition of an asset over a period of time in order to bring it to current prices after taking inflation into consideration.

Indexation is calculated through a mechanism using a Price Index which is adjusted for inflation. The Price Index adjusts for inflation at the time of purchase of an asset as well as at the time of its sale.

Indexation benefits are availed on long-term investments like debt fund and other asset classes. Indexation is a tool which helps investors to not get affected by the rate of inflation when it comes to calculation of returns on investment. Indexation can be of great relief when it comes to taxable income. It doesn’t let the returns on investment drain away into taxes by adjusting the prices of investments. Investors can use indexation to lessen their tax liability. Investors should know that indexation are not applicable to equity funds.

How does Indexation work in debt mutual funds?

Let us assume there is an Investor Mr. A who invested ₹ 10,000 in a debt fund in July 2016. He bought the units at the NAV of ₹ 10. Mr. A redeemed his investment in August 2019 when the NAV was at ₹ 20 per unit. So, when Mr. A did the redemption, the value of his investment ₹ 20,000 and he made capital gains of ₹ 10,000.

The benefit of indexation will play its role here as Mr. A does not have to pay taxes on this entire capital gains i.e. ₹ 10,000. Mr. A kept his investment for three years and long term capital gains are taxed at the rate of 20% with Indexation.

In order to calculate the indexation, there is a prescribed formula

Cost of Acquisition (ICoA) = Original cost of acquisition * (CII of the year of sale/CII of year of purchase)

Where, CII = Cost Inflation Index which is updated on Income tax department’ website on yearly basis. The CII for the financial years 2001-2002 till 2020-2021 has been given in the below table.

As can be seen from the above table that CII of the year 2016-17 was 264 and CII for 2019-2020 was 289. Therefore, ICoA will come out to ₹ 10,947 (10,000 * 289/264). Hence, for Mr. A, capital gains in this case comes out to be = ₹ 9,053 (20,000 – 10,947) instead of ₹ 10,000 without indexation benefit. Mr. A managed not to pay tax on ₹ 947 of his gains. He will pay 20% tax for the amount ₹ 9053. Hence, his tax will be 20% of ₹ 9053 = ₹ 1,811.

From the above mentioned example, it could be observed that indexation is a powerful tool to reduce the tax liability of investors however it would be more useful when holding period is longer since capital gains tax can further come down.

Conclusion

Indexation is a boon for investors in times of inflation. Indexation helps investors to reduce their tax liability on long-term capital gains from debt mutual funds and enhance their earnings. It saves investors from the effects of inflation since returns are adjusted as per CII. Investors get attracted to debt mutual funds because they earn decent returns even after tax subtractions.