Indexation in Mutual Funds

Learn how indexation helps investors minimise tax liabilities on capital gains, empowering you to make informed investment decisions for your financial goals.
Indexation in Mutual Funds
3 mins read
26 March 2024

Investing in mutual funds is a prudent way to grow your wealth over time. However, as a smart investor, it is essential to be aware of tools and strategies that can enhance your returns and protect your investments. One such strategy that can play a significant role in achieving these goals is indexation. It is important to know that the benefits of indexation are only available on capital gains earned on through debt mutual funds.

Unravelling Indexation

Fundamentally, indexation involves modifying the initial cost of an asset to account for inflation when computing profits or losses. This idea recognizes how increasing prices can influence the worth of your investments. While the apparent value of an investment might rise over time, its actual value could stay unchanged or even decline due to the unrelenting impact of inflation.

Applying Indexation to Mutual Funds

When it comes to mutual funds, indexation plays a crucial role in determining the taxable gains on your investments. When you sell your mutual fund units, any profit you make is subject to capital gains tax. However, if you've held your investments for the long term, the gains might not be as substantial when adjusted for inflation. This is where indexation steps in to provide a fairer picture of your gains.

A duration of 36 months or beyond is categorised as the long term for Debt Funds. Any tenure less than 36 months for Debt funds is classified as short term, and the resulting gains are integrated into the investor's income for tax computation. (For Equity mutual funds, long-term means a holding period of 12 months or more.)

Benefitting from Indexation in Mutual Funds

The primary benefit of indexation in mutual funds is its ability to lower your tax liability on capital gains. By adjusting the purchase price of your investment for inflation, indexation effectively reduces the taxable portion of your gains. This means that you are taxed only on the real gains, which is the portion that exceeds the impact of inflation. Consequently, indexation can significantly reduce the tax burden on your investment returns, allowing you to keep more of your hard-earned money.

Calculating Inflation

The formula for calculating indexed cost is straightforward:

Indexed Cost = Actual cost or cost of purchase × (CII of the year of sale / CII of the year of purchase)


Here, CII or the Cost Inflation Index, is a tool used to measure the changes in inflation over time. It is released by the government each financial year. Let us see the Cost Inflation Index table from the financial year 2010-11 to 2023-24:

Financial year

Cost Inflation Index (CII)

2010-11

167

2011-12

184

2012-13

200

2013-14

220

2014-15

240

2015-16

254

2016-17

264

2017-18

272

2018-19

280

2019-20

289

2020-21

301

2021-22

317

2022-23

331

2023-24

348


Let us understand this with an example:

Imagine you invested in a mutual fund with an actual cost of Rs. 2,00,000 in the year 2015. The CII for that year was 254. You decide to sell the investment in 2023, when the CII has risen to 340.

Indexed Cost = 2,00,000 × (340/254) = Rs. 2,68,504

If you sell the investment for Rs. 3,50,000, your indexed capital gain will be:

Indexed Capital Gain = Selling Price - Indexed Cost

= 3,50,000 - 2,68,504

= Rs. 81,496

The tax payable on this indexed capital gain will be significantly lower on Rs. 81,496 as compared to the tax on the nominal gain of Rs. 1,50,000.

Conclusion

Inflation is an inevitable force that can erode the value of your investments over time. However, with the strategic use of indexation, mutual funds provide you with a mechanism to mitigate the impact of inflation on your investment returns. By accounting for inflation when calculating capital gains tax, indexation ensures that you are not unfairly taxed on gains that are merely compensating for rising prices. As you navigate the world of investments, harnessing the power of indexation can be a smart move to safeguard the real value of your investments and optimise your after-tax returns.