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Indexation is when you get discount on taxation by considering inflation. Enjoy indexation benefits through debt mutual funds indexation.

How to Reduce Tax Liability on Debt Funds with Indexation?

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"How to Reduce Tax Liability on Debt Funds with Indexation?"

Sayan Das

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<p>
    Worried about inflation affecting your returns on debt funds?
   </p><p>
    Fret not! Beat the inflation with indexation.
   </p><h2>
    What is Indexation?
   </h2><p>
    Indexation is a method of adjusting the purchase price of an asset to consider inflation between its purchase and sale. In other words, it allows you to increase the purchase price based on the inflation rate, enabling the estimation of gains or losses in real terms. Indexing the purchase price reduces the overall gain and subsequently lowers the tax liability.
   </p><h2>
    How Can You Get Indexation Benefits?
   </h2><p>
    You can get the maximum indexation benefit with debt mutual funds investments. Long-term capital gains on debt funds are taxable at the rate of 20% with the benefit of indexation.
   </p><p>
    To check the indexation benefit of your investment, you can check the indexation rate. For the period of your investment, you can calculate indexation rates by using the CII (Cost Inflation Index) figures. The CII is declared annually by the government. As the inflation rate keeps changing every year, the CII rate too varies annually. The CII rates are 75% of the average annual rise in retail inflation.
   </p><p>
    Once you have fetched the indexation rate for your investment, here’s how you can calculate the readjustment on your debt mutual fund returns.
   </p><h3>
    Examine this calculation
   </h3><p>
    Say you invested ₹1,00,000 in a debt mutual fund scheme with a four-years maturity period in June 2022. Now, suppose after four years, you will redeem your debt mutual fund investment and get ₹1,20,000. You will redeem your investment in May 2026 which would come under the 2026-27 financial year. Therefore, your return on your investment or capital gain was ₹20,000 or 20% of your principal investment.
   </p><h3>
    Tax on your capital gains
   </h3><p>
    Without the indexation calculation in debt mutual funds, your entire capital gain of ₹20,000 looks taxable. Since you had invested in a scheme for more than a year, Long Term Capital Gains (LTCG) tax would be applicable. However, with the debt mutual fund indexation, you do not have to pay LTCG for your entire capital gains.
   </p><h2>
    Calculating LTCG Tax with Indexation
   </h2><p>
    Here is the formula for calculating indexation:
   </p>

<p>Therefore, your final capital gains to be taxed under LTCG will be reduced from ₹20,000 to ₹17,281 due to indexation.</p><h2>Influence of Inflation on Indexation</h2><p>The benefit of indexation would apply only if inflation is positive. If the inflation rate turns negative, you might not get any help from indexation. This is because indexation does not apply in a deflationary situation. So, would you have to pay more taxes than your capital gains if the inflation falls below the 2022 level in 2026?</p><p>No. This is because CII is calculated as 75% of the changes in CPI inflation from the previous year.</p><p>Therefore, even if the CPI inflation falls drastically, its difference from the previous year’s CPI can be greater. Thus, you will not have to pay LTCG tax for a lower capital gains figure than the actual, even if the inflation falls in 2026.</p><p>Also, you must stay invested for at least three years in a debt mutual fund to get indexation benefits.</p><h2>Conclusion</h2><p>To optimise returns, it's essential to conduct thorough due diligence when calculating indexation benefits and determining the most suitable taxation system based on factors such as your income level and tax bracket. Traditional savings schemes like fixed deposits do not incorporate indexation adjustments, leading to significantly higher tax obligations on your earnings. You have two choices for calculating your total tax liability: employing an indexation calculator that considers inflation rates or using a standard calculator for tax rates without adjustments. By comparing your overall tax liability and profits in both scenarios, you can easily select the most advantageous tax payment method, ultimately maximising your returns.</p><h2>Unlock Tax Efficiency and Investment Opportunities via Fi</h2><p>Minimise your tax burden on debt funds through indexation and optimise your investment potential with Fi. Users can find several investment options on the Fi app. Be it short-term or long-term — it's easy to invest with a simple swipe of your phone's screen. If you want to save up for a short-term goal &amp; earn interest on it, select our super-flexible Smart Deposit. If you're looking for higher/stable returns, opt for a Fixed Deposit.</p>

<h2>
    Frequently Asked Questions
   </h2><h3>
    1. What is indexation in debt mutual funds?
   </h3><p>
    Indexation is simply the readjustment of returns from a debt mutual fund by considering inflation. This inflation adjustment or indexation can reduce your final taxable capital gains from your redeemed funds.
   </p><h3>
    2. Are mutual funds eligible for indexation?
   </h3><p>
    Debt mutual funds are eligible for indexation benefit on the capital gains. That means the tax burden on your capital gains gets adjusted for inflation.
   </p><h3>
    3. Are debt mutual funds taxable?
   </h3><p>
    Yes, debt mutual funds are taxable. If debt funds are held for a period of more than a year, they are taxable under the Long Term Capital Gains (LTCG) tax. If you hold a debt mutual fund for less than a year, you will have to pay Short Term Capital Gains (STCG) tax.
   </p>