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Indexation Basics In Mutual Funds

In India, mutual fund schemes that invest at least 65 percent of their assets in the stocks and related instruments are considered equity-oriented, while the rest are debt-oriented. Indexation is a taxation concept that applies to debt-oriented schemes.

Regarding finances and long-term capital gains, Indexation in mutual funds is a popular concept. Debt fund indexation is essential in determining whether or not an investment will generate a good return and the total tax on such assets. It assists investors in lowering the taxes they spend on their mutual debt fund investments, reducing their losses while increasing their profits.

Mutual Fund

What is Indexation in mutual funds?

Indexation in mutual funds refers to adjusting the purchase price of an asset to avoid capital gains tax. The Income Tax authority allows the asset’s cost at the time of purchase to be indexed, i.e., adjusted or inflated, to reflect its current value after inflation. This primarily adjusts the asset’s purchase price to a higher value, lowering the capital gain and providing investors with a tax break on profits.

Mutual fund indexation is relevant to long-term investments, such as debt funds and other asset classes, that reduce a person’s tax liability by utilizing the concept of inflation, resulting in mutual fund indexation benefits.

To make it simpler, let’s take an example: Say if apples cost Rs. 100 per dozen last month, and you buy and store them. Now this month, the price has risen to Rs. 110 per dozen. You now sell them, and because you had ripe-and-ready-to-eat apples for 120 for a dozen.

So, now you make a profit of Rs 20. But keep in mind that the market price for that dozen today is Rs. 110. So, the government allows us to change your purchase price to reveal the inflationary increase for tax purposes. As you can see, the benefit of Indexation reduced your taxable gains from Rs.20 to Rs.10, lowering your tax liability.

What are the benefits of Indexation?

Here are some of the significant benefits of Indexation:

  • Indexation benefits on debt funds reduce investors’ tax liability, resulting in higher profits and, as a result, increased investment.
  • Indexation allows investors to increase the purchase price of an asset, thereby reducing the negative impact on cost caused by inflation.
  • Indexation ensures that investments generate high returns for investors because only the tax on LTCG gains is adjusted and reduced, rather than the absolute gains.
  • The concept enables investors to earn a handsome profit even after considering post-tax deductions, lowering their taxable income.
  • Indexation in mutual funds adds stability and liquidity, making mutual funds a more appealing investment instrument for investors than traditional fixed deposits.

Is Indexation available only to debt funds?

Currently, the indexation benefit is only available for calculating long-term capital gains (LTCG) taxes on debt funds, not equity funds. So, if you retain your equity investments for more than a year, the gains are taxed at a flat rate of 10%. In the case of debt funds, however, you must hold the fund for at least three years before capital gains are taxed at 20% after providing the indexation benefit.

However, keep in mind that while the indexation benefit is not accessible in equity, the tax rate is lower. Now, whether or not this works in your favor will be determined by the accumulated levels of capital-gain tax and the current inflation rate during your holding period. So, these factors will determine whether or not the indexation benefit is advantageous to you.

Conclusion

Indexation in mutual funds is a powerful instrument for saving taxes and lowering one’s long-term capital gain liability. The tool is handy for debt fund indexation, as it reduces the taxable gains that reduce the returns from these investments.

The tax benefits on investments are an essential factor influencing anyone’s investment decision. The indexation benefit of debt-oriented mutual funds gives investors an advantage over comparable investment options. Investors must therefore choose their investment option carefully, keeping in mind their investment goals n and the post-tax returns available on mutual funds.

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