Indexation in Mutual Funds – meaning, benefits, and more

Are you concerned about the rise in inflation? Has ‘mahangai’ become the most spoken word in your house? If you have been keeping up with domestic and global news, you will notice how inflation, which is the rate at which the price of things and services is rising, has been increasing almost every month, over the last year. In this scenario, you will find yourself worrying about the future and about how far your savings will go in such a high-inflation ecosystem. This is where the concept of indexation in mutual funds comes in. Let us take a look at indexation in mutual funds, its meaning, benefits and other important details.

What is indexation?

If you have been worried about the impact of inflation on your savings and assets, it is time for you to turn to indexation and reap the benefits of this facility which is offered under Income Tax regulations. You can use indexation to efficiently prevent the drainage of your investment returns, in the form of the tax you pay on the returns accrued, as long as you stay invested for the longer term. You can enjoy the benefits of indexation in long-term investments, including investment in debt funds and other asset classes. Using indexation, you can adjust the purchase price on your investments, in line with the rise in inflation. This means that you can increase the purchase price on the investment, which brings down the effective returns you have accrued. Consequently, the lower returns lead to a lower tax outgo, ensuring that you end up holding on to a larger part of the profit you earn on your investments. In this way, indexation helps you fight with the underlying wealth drain on two fronts – inflation and tax outflow.   

How does indexation work in mutual funds?

To better understand indexation in mutual funds, let us take a look at the concept of capital gains. The term capital gain refers to the rise in the value of your investment, during the investment tenure. For instance, suppose you invested in mutual funds two years ago, and, at the time of investment, the net asset value of the fund was Rs. 100. Over the last two years, this NAV has increased to Rs. 200, increasing the value of your investment in a corresponding manner. This rise in value can be calculated to a capital gain of Rs. 100 per unit, when you redeem the investment. When calculating capital gains in debt funds, in case of long term investments, you can find how much capital gains you have earned by indexing the purchase price on the fund. Indexation helps you incorporate the general increase in prices. The idea is that just like the cost of goods and services increases over a period of time, even the cost of your investments also increases. This means that after adjusting for the increase in the cost of your acquisition, the gains made (for the purpose of calculating tax) reduces.

According to the Income Tax regulation, long-term capital gains on debt funds are taxed at 20%, after indexation benefit. Indexation is not applicable in the case of equity fund investments. Therefore, if you are selling your debt fund units after a period of three years, you can use indexation to lower the capital gain and the tax outgo. For instance, when the NAV of your fund increased by Rs. 100, you can use indexation to show that the actual rise in NAV, after adjusting for inflation, was only around Rs. 80. Thus, instead of paying tax on Rs. 100, with the help of indexation, you end up paying tax on Rs. 80, thereby reducing your overall tax outgo.

To find the exact Indexed Cost of Acquisition (ICoA) on your debt fund, you can use the following formula –

ICoA = Original cost of acquisition * (Cost Inflation Index of the year of sale/Cost Inflation Index of year of purchase)

In this scenario, the longer you hold on to your investment, the higher will be the indexation benefit you enjoy.

Benefits of indexation

The two biggest benefits of indexation are that it helps you fight inflation and reduce your overall tax outgo. The dual benefit helps you monetise your savings while limiting the tax out-go, making it a win-win solution. Indexation is one of the biggest reasons why people prefer to invest in debt funds when it comes to long term investment. While the interest earned on bank FDs attract income tax, according to your tax bracket, on a yearly basis, returns on debt funds enjoy indexation and end up being taxed only when you actually redeem the units.

In conclusion, if you have been looking for a great way to boost the potency of your savings, while also limiting the amount of tax you pay, then indexation in mutual funds can be your best friend. Start investing right away and enjoy this effective way of combating inflation and taxation.

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