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How To Reduce Tax On Debt Mutual Fund Returns With Indexation

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How To Reduce Tax On Debt Mutual Fund Returns With Indexation

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Think about the price you paid for a half-litre packet of milk five to six years ago and compare it with the current prices. 

We all experience that the prices of the essential things we need in our daily lives keep rising. This rise in prices is called inflation. 

The debt mutual fund indexation considers inflation by readjusting your returns accordingly. But why do we need it?

Inflation can make your investments inadequate for your goals if not accounted for. So, what if there was a way that investments could give you a discount on tax by accounting for inflation? 

Yes, this discount on taxation by considering inflation is called indexation. And you can get this indexation benefit by investing in debt mutual funds. 

Let us learn about the debt mutual fund indexation and its benefits in detail. 

What is indexation?

Indexation, in simple terms, means the readjustment of returns by considering inflation. It indirectly calculates the loss on your debt mutual fund investment returns due to inflation. 

The returns after calculating indexation are inflation-adjusted returns and are generally lower than your actual returns. 

When you calculate your taxes based on these inflation-adjusted returns, your tax liability becomes lower. Thus you have to pay a lower amount of taxes for indexed returns. 

How can you get the indexation benefits? 

You can get the indexation benefit in debt mutual funds by investing in debt funds for three years or more. 

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. The government issues the CII figures every year, representing the inflation rate for that year. 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. 

Once you have calculated the indexation rate for your investment, here’s how you can calculate the readjustment on your debt mutual fund returns. 

Examine this calculation: 

Say you invested ₹1,00,000 in a debt mutual fund scheme with a four-years maturity period. You invested this amount in June 2022. June 2022 falls in the 2022-23 financial year. 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. 

Tax on your capital gains

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. 

Calculating the LTCG tax after considering indexation

Here is the formula for calculating indexation: 

Indexation = Actual price paid for the investment x (CII for the fund sale year/CII for the fund investment year). CII for 2022 is 331. Now, suppose that the CII for 2026 rises to 340
Indexation = 1,00,000 x (340/331) = 1,00,000 x 1.03 = ₹1,02,719

Now, your capital gains after considering indexation will be = ₹1,20,000 - ₹1,02,719 = ₹17,281 

Therefore, your final capital gains to be taxed under LTCG will be reduced from ₹20,000 to ₹17,281 due to indexation. 

Indexation benefits and the rise and fall in inflation

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? 

No. This is because CII is calculated as 75% of the changes in CPI inflation from the previous year. 

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. 

Also, you must stay invested for at least three years in a debt mutual fund to get indexation benefits. 

Summing up

We all want to save our investment returns from inflation. It reduces the value of our returns and pushes us further away from our financial goals. Debt mutual funds indexation is like a discount on taxes that can make up for the loss of our investment value due to inflation.

Indexation benefits on debt mutual funds can reduce your final tax burden on your capital gains. Thus, where the value of your capital gains amount declines due to inflation, you get covered for it by paying lesser inflation-adjusted capital gains taxes. 

The indexation benefit in debt mutual funds makes them a better choice for those looking for stable returns with a lower risk. 

Frequently asked questions

1. What is indexation in debt mutual funds?

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. 

2. Are mutual funds eligible for indexation?

Mutual funds like 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.

3. How do you calculate capital gains on mutual funds with indexation?

To calculate the capital gains on mutual funds with indexation, you first need to calculate the indexation rate. 

Suppose you invested ₹1,00,000 in a mutual fund in 2022 and will get ₹1,20,000 on redemption in 2026. 

Now, your capital gains for this investment will be ₹20,000.

Indexation rate = Invested amount x (CII for redemption year/ CII for the purchase year) 

If the CII for 2022 is 331 and it rises to 340 for the year 2026. 

Indexation = 1,00,000 x (340/331) = 1,00,000 x 1.03 = ₹1,02,719

Now, your capital gains after considering indexation will be = ₹1,20,000 - ₹1,02,719 = ₹17,281 

Therefore, your final capital gains to be taxed under LTCG will be reduced from ₹20,000 to ₹17,281 due to indexation. 

4. Are debt mutual funds taxable?

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. Furthermore, if you hold a debt mutual fund for less than a year, you will have to pay Short Term Capital Gains (STCG) tax.

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