Understanding Indexation Benefit in Mutual Fund

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For most investors, one of the goals when investing in mutual funds is to get returns which are higher than the inflation rate. To achieve this, investors take advantage of indexation in mutual funds to reduce taxable gains. In this article, we will cover what is indexation in mutual funds and how you can benefit from it.

What Is Indexation in Mutual Funds?

In mutual funds, indexation is the process of modifying an investment's initial purchase price to take inflation into account depending on how long it was held. This adjustment of cost is done based on Cost Inflation Index (CII) which is a metric published by government. This is to ensure that as an investor you are only taxed on inflation adjusted gains rather than gains that may be inflated by rising prices over time.

Why Is Indexation Important in Mutual Fund Taxation?

For those who want to optimize their mutual fund portfolio to build their wealth over an extended period, should plan accordingly for indexation for the following benefits:

• Reduces Taxable Gains: Indexation allows investors to adjust the purchase price of their investment for inflation, effectively reducing the capital gains subject to taxation.
• Ideal for Long-Term Investors: The longer you hold the investment, the greater the inflation adjustment and the higher the tax savings.
• Ensures Actual Profit is Taxed: Indexation makes sure you’re taxed only on actual gains, not inflated profits, preserving more of your earnings.

How Indexation Works in Mutual Funds?

Indexation adjusts your investment cost in mutual fund for inflation. As an investor to understand the benefits of indexation, it’s important to understand how it works. Here’s an overview of indexation process:

1. Identify which capital assets are eligible for long-term capital gain indexation benefits (e.g., debt mutual funds).
2. The original purchase price of mutual fund is adjusted using the Cost Inflation Index (CII). This is calculated based on the original purchase price and the CII of the year of sale.
3. By increasing the cost of purchase as per inflation adjustment, the capital gains is reduced and subsequently the amount of payable tax.

For example, an investor who invested in debt funds in 2016 and the value of investment grew to 200% of the original amount. With indexation the cost of acquisition is readjusted to 120% of the original investment. This reduces the taxable gain to 80% (200 – 120).

Also Read: Tax on Equity Mutual Funds

How to calculate Indexation in Mutual Funds

To calculate mutual fund capital gains with indexation, follow these steps:

1. Step 1: Use the 2024–2025 fiscal year's Cost Inflation Index (CII), which is 363.
2. Step 2: Apply the Indexation Formula which is Indexed Cost of Acquisition = Purchase Price x (CII in year of sale ÷ CII in year of purchase).
3. Step 3: Compute the Taxable Gain by subtracting redemption value from indexed cost of acquisition.

Example of Indexation Benefit Calculation

The following example shows how indexation can reduce the taxable capital gain on a long-term debt mutual fund investment:

As per this calculation, the investor must pay tax only on INR 36,001 instead of the full INR 50,000 gain. This lower taxable amount is on basis of 20% tax with indexation benefits offering savings on long-term investments.

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Which Mutual Funds are Eligible for Indexation Benefit?

Indexation benefits earlier were available on several mutual fund types. However, the Finance Act 2023 removed indexation benefits for investments made on or after April 1, 2023, in most non-equity mutual funds.

In 2025, the following mutual funds will be eligible for the indexation benefit:

• Debt Mutual Funds
• Debt-Oriented Hybrid Funds
• International Funds/ Fund of Funds (FoFs)

Indexation in SIPs

If you’re wondering whether indexation benefits are available for SIPs in mutual funds, the answer is yes. However, each SIP instalment is treated as a separate investment, so investments made before April 1, 2023, and held for 36 months qualify for indexation. After this date, investments will be subject to taxation at the rate of your income slab.

Impact of Indexation on Long-Term Capital Gains (LTCG)

By adjusting the purchase price for inflation, capital gains tax indexation can drastically lower the amount of tax due on long-term investments. Prior to the 2023 tax law changes, this benefit was particularly pertinent for non-equity mutual funds.

The following table illustrates the effects of indexation on long-term capital gains for various mutual fund categories:

How to Maximize Indexation Benefits

If you want to leverage the benefits of indexation for your mutual fund investments in India to increase your post-tax returns, here are some tips to maximize indexation benefits:

Consider investing in debt mutual funds and certain hybrid mutual funds with less than 65% equity exposure which is applicable for indexation benefits. It’s important to note that for investments made after April 1, 2023, indexation benefits on new debt funds have been withdrawn, but older investments are still eligible.

As an investor, your investment strategy must be set for long term, to fully leverage the indexation benefits. For e.g. a five-year holding period can bring your effective tax rate down from 20% to as low as 6-7%.

Use the Cost Inflation Index (CII) for both the year of investment and sale to calculate the indexed cost of your mutual funds. You can use this to report actual capital gains that have been adjusted for inflation. Make sure to check the latest CII updates by the government.

A higher CII in the sale year means a higher indexed cost, therefore lower tax on gains. If you are planning to redeem, make sure you are aware of change in CII rates and other taxation laws.

If your mutual fund portfolio already consists of high to medium risk investments, having a debt fund not only offers indexation benefits but also stability to balance your portfolio during any changes in market conditions.

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Conclusion

While the scope of indexation has been narrowed due to recent tax rule changes, investors can still enjoy indexation benefits by making strategic investments in mutual funds. By being aware of how indexed gains are calculated and which mutual funds are eligible for indexation, you can make the most of this benefit.

Consider opening an investment account with DBS Treasures which gives you convenient access to invest in mutual funds and other securities. You can make smart investments, using research reports and market updates provided from DBS group research.

Disclaimer: This article is for informational purposes only and should not be considered financial advice