Benefits of indexation and mutual funds

When an investor invests in a mutual fund scheme, the returns received at the end of the investment tenure are called capital gains. Similarly, the tax that is to be paid on these gains is referred to as the capital gains tax.  

Indexation as a concept is a tool employed to reduce the burden of this capital gains tax so that an investor pays a lesser amount as tax. It does that by adjusting the original investment value against inflation.

Debt funds indexation helps in determining if the investments will generate good returns. Besides, it aids to find out the total tax on such investments. For investors, it reduces the taxes they are liable to pay on their debt mutual fund investments, lowering their losses while increasing their profits.

Indexation involves recalculating the purchase price of an asset, so as to prevent capital gains tax. When an investor redeems the debt mutual funds after three years, the Income-tax (I-T) department allows for the cost of the asset at which it is purchased to be indexed (adjusted or inflated), over a period of time as per its current value after taking inflation into account.

The I-T department releases the Cost Inflation Index (CII) every year based on which the indexation benefit is computed. For instance, the CII for the financial year (FY) 2022-23, is 331. 

By increasing the purchase price, an investor’s indexed profit reduces, and subsequently so does the tax liability.

If an investor sells the asset after three years from the date of purchase, the gains or the profits earned from that transaction are termed long-term capital gains (LTCGs). However, if an investor sells that asset in less than three years, then the gains earned are termed short-term capital gains (STCGs). 

The benefit of indexation is available only for LTCGs from other than equity-oriented mutual fund schemes in mutual funds.

To find the actual or the indexed price of the asset, the purchase price is multiplied by the CII for that year and divided by the CII for the purchase year. 

The value thus obtained is considered the inflation-adjusted purchase price, and can be deducted from the selling price to obtain capital gains. Tax liability on LTCGs applicable is then calculated at 20 per cent and addition of surcharge, with indexation, and 10 per cent and addition of surcharge, without indexation.