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Indexation in Mutual Funds: Benefits, Calculation, and Application
‘Indexation’ is a pivotal term for investors during decision-making. It is also considered vital to reduce tax liabilities associated with investments, especially in debt mutual funds. Although calculating Indexation is quite easy, many investors may find it confusing or fail to consider its importance. Worry no more, as you are at the right place. Urban Money presents herein a detailed overview of indexation and its calculation. We will also cover the details, such as the cost indexation rate, how it is relevant to tax exceptions, and other pertinent information regards Indexation Benefits in mutual funds. Let’s dive in.
The Basic Concept of Indexation
Indexation is a type of financial technique. It enables you to adjust payments, values, or other monetary figures to show how inflation has stimulated prices. In essence, it involves updating the initial purchase price of an asset to correspond with today’s financial cost. This adjustment is vital for investors because it offers a more accurate measure of their investment’s profits (or losses) while the asset sells. The primary objective of indexation, however, is to preserve the real value of money. This ensures that its purchasing power remains stable regardless of typical changes in the overall price level as time progresses. For more clarity about indexation rates, follow the example given below.
Let’s consider an investment in a mutual fund bought for ₹10,000 in 2010 and sold for ₹15,000 in 2020. At first glance, it seems like a ₹5,000 gain. However, if we consider a cumulative inflation rate of 20% over this period, the original ₹10,000 in 2010 would be worth ₹12,000 in 2020. Thus, the actual gain is not ₹5,000, but rather ₹3,000.
Formula for Indexation
Let’s have a look at the applicable formula to calculate indexation:
Indexed Purchase Price = Original Purchase Price × (CII of the given year / CII of the base year)
Where,
- CII of the base year: The rate of Indexation (CII) when you buy the asset.
- CII of the given year: The rate of Indexation (CII) when you sell the asset.
Note: CII stands for Cost Inflation Index, which the Income Tax Department determines annually.
Indexation Rate or Cost Inflation Index (CII)
The indexation rate is a metric. It is also known as the Cost Inflation Index (CII) and is decided by the tax authority. The CII normally quantifies the inflation rate for every financial year in India. Knowing this indexation rate is crucial for calculating indexation; without it, the calculation can’t be performed. The indexation rate further plays a pivotal role in taxation, as it considers the impact of inflation on the asset’s price, which ultimately decreases your tax liability. I.e., the higher the CII, the larger the inflation adjustment and the lower the taxable amount.
Let’s look at the last 10 years of indexation benefits in India.
Financial Year | Assessment Year | Cost Inflation Index (CII) |
2023-24 | 2024-25 | 348 |
2022-23 | 2023-24 | 331 |
2021-22 | 2022-23 | 317 |
2020-21 | 2021-22 | 301 |
2019-20 | 2020-21 | 289 |
2018-19 | 2019-20 | 280 |
2017-18 | 2018-19 | 272 |
2016-17 | 2017-18 | 264 |
2015-16 | 2016-17 | 254 |
2014-15 | 2015-16 | 240 |
How to Calculate Indexation?
To calculate indexation, you need to follow these steps:
Step 1: Assess the entire sum of money it charges to buy an asset
Step 2: Find out the indexation rate at the time of purchase and the indexation rate at the time of sale.
Step 3: Divide the indexation rate at the time of sale by the indexation rate at the time of purchase.
Step 4: Multiply the resulting figure by the total purchase cost to get the indexed price of the asset.
Step 5: Subtract the indexed price from the sale price and receive the actual capital profits.
Let’s follow the example of indexation calculation to understand better. Suppose you bought a property for Rs. 50 lakhs in 2010 and sold it for Rs. 1 crore in 2020. The CII for 2010 was 167, and the CII for 2020 was 301. The tax rate for long-term capital gains is 20%.
- The acquisition cost of the property is Rs. 50 lakhs.
- The CII of the base year (2010) is 167.
- The CII of the given year (2020) is 301.
- The indexation factor is 301 / 167 = 1.8024
- The indexed cost of the property is 1.8024 x 50 lakhs = Rs. 90.12 lakhs
- The capital gain is Rs. 1 crore – 90.12 lakhs = Rs. 9.88 lakhs
- The tax liability is 20% of 9.88 lakhs = Rs. 1.976 lakhs
Key Benefits of Indexation
There are two major indexation benefits you can expect as you learn to calculate indexation:
Reduce Tax Burden: Indexation enables you to adjust the asset’s value based on the economy’s inflation level. This technique favourably results in a lower gain when the tax is calculated upon selling your asset. Hence, indexation rates are acknowledged as a vital tool to reduce tax liability, making it a financially savvy move for investors.
Assist Decision Making: Indexation considers that the value of money evolves over time. This guarantees that profits are assessed in terms of current monetary value. As such, indexation gives a more precise and realistic view of the profit, serving as a pivotal tool for making well-knowledgeable decisions.
Application of Indexation in Debt Mutual Funds
Understanding and leveraging the idea of indexation in the mutual fund can substantially enhance the efficiency of your investment. Namely, when you sell your assets in a mutual fund, you make a capital benefit, distinguishing between the selling and purchase fees. Without indexation, this complete gain is taxable. However, with indexation advantages, you could increase the acquisition price to account for inflation, lowering the taxable benefit. This discount is especially considerable for long-term capital gains on debt mutual funds, which are taxed at 20%. Notably, according to the Finance Act 2023, those who invested from 1 April 2023 are not eligible for this tax benefit. I.e., mutual funds will now be taxed at the relevant income tax slab with no adjustment for inflation. But those who invested before March 31 can still avail of the indexation benefits.
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