Indexation Benefits in Debt Mutual Funds Over Traditional Fixed Income Instruments

When fixed deposit rates are so low ,then it’s natural for Investors to try & look for alternatives to bank FDs/Traditional Fixed Income Investments . And one very obvious alternative is the Debt mutual fund. Debt funds have historically delivered returns better than fixed deposits.

 

One clear advantage that debt funds have over FDs (fixed deposits),is their tax treatment. And that too ,Indexation benefit which allows debt funds to drastically cut down  tax outgo and improve post-tax returns.

 

The  tax rate depends largely upon whether the capital gain was earned over a short or a long-time period.

 

Latest Debt Fund Taxation Rules (FY 2020-2021):

 

• Short Term Capital Gains (STCG)– Gains made on investment in Debt Mutual Funds held for less than 3 years (or 36 months). And this Short Term Capital Gains (or STCG) on Debt funds are taxed as per the investor’s income tax slab rate.

 

• Long Term Capital Gains (LTCG) – Gains made on investment in Debt Mutual Funds held for more than 3 years (or 36 months). And this Long Term Capital Gains (or LTCG) on Debt funds is taxed at 20% with indexation

 

What is Indexation?

 

Indexation is a way to adjust capital gains as per the prevailing inflation index. So via indexation, the purchase price of an investment is adjusted for inflation (usually upwards). By increasing the purchase cost, the capital gain for tax purposes gets reduced. As a result, the actual tax you pay, also reduces significantly.

The government regularly releases the Cost of Inflation Index (CII) which is used to index (or adjust) the cost of acquisition of the debt mutual fund units

 

Examples of Indexation Benefits in Debt Mutual Funds

 

Suppose you invested Rs 20 lakhs in a  debt fund in Sep 2016. After a little more than 4 years, i.e. in Dec 2020, the value of your debt fund investments has become Rs 28 lakhs.

Now you plan to sell your debt fund investment at this point.

So mathematically speaking, you made capital gains of Rs 8 lakhs, i.e. Rs 28 lakhs – Rs 20 lakhs. Is that your actual profit? Answer is No

 

This gain was made after a period of 4 years, which is more than 3 years requirement for capital gains qualifying as Long Term Capital Gains for Debt Funds.

So do you pay tax on this full Rs 8 lakh gain at the time of selling?

 

No,once again.

 

Cost of acquisition = Rs 20 lakh

• CII number for 2016-17, the year of purchase = 264
• CII number for 2020-21, the year of sale = 301

 

So the indexed cost price of acquisition is calculated using the formula:

Indexed Cost = Actual Cost * (CII of Sale Year / CII of Purchase Year)

And in our example, this comes out as follows:

= Rs 20 lakh * (301/264) = Rs 22,80,303