Indexation in mutual funds in India is a tax-saving tool that adjusts the purchase cost of investments for inflation, thus reducing taxable gains. Primarily applicable to debt mutual funds, it’s a key factor for long-term investors. Thus, understanding indexation is vital. How does it work? Let’s break it down.
What Is Indexation in Mutual Funds?
Indexation allows investors to inflate the purchase price of units using the Cost Inflation Index, published annually by the Income Tax Department. This lowers the taxable capital gains when redeeming debt funds held over three years. For example, a ₹1 lakh investment in a debt fund in 2020, sold in 2024, uses CII to adjust costs, cutting tax liability. Since April 2023, indexation benefits were removed for new debt fund investments, per SEBI, but pre-2023 holdings still qualify.
How Is Indexation Calculated?
When you sell mutual fund units after holding them for more than three years, you consider the gains as LTCG. Under this method, you adjust the purchase price for inflation using the CII. The formula is:
Adjusted Cost = Original Cost × (CII of Sale Year / CII of Purchase Year).
If you invested ₹1 lakh in 2020 (CII 280) and sold in 2024 (CII 340), the adjusted cost is ₹1 lakh × (340/280) = ₹1.21 lakh.
Taxable gain is the sale price minus this adjusted cost. Post-2023, new debt fund investments face slab-rate taxation without indexation. Moreover, equity funds don’t qualify for indexation, facing 20% short-term or 12.5% long-term tax (over ₹1.25 lakh), per IBEF.
Benefits: Tax Savings and Higher Net Returns
The primary benefit of indexation in mutual funds in India is reduced tax on long-term capital gains. Without indexation, gains are taxed at slab rates (up to 30%). With indexation, the effective tax rate drops significantly. For instance, a ₹1 lakh investment at CII 280 (2020) sold for ₹1.5 lakh at CII 340 (2024) adjusts the cost to ₹1.21 lakh, taxing only ₹29,000, per the Economic Times. In 2024, debt fund AUM hit ₹14.5 lakh crore, per AMFI, with indexation thus boosting net returns for legacy investors. In addition, it encourages holding debt funds longer.
Impact on Investors and Future Outlook:
The removal of indexation for debt mutual funds has led to an increased tax liability for investors. For example, an investment of ₹10 lakh made in March 2023, with an expected annual return of 7%, would grow to ₹12.25 lakh by March 2026. Under the old tax regime, with a 4% indexation rate, the adjusted cost would be ₹11.24 lakh, thus resulting in a capital gain of ₹1 lakh and a tax of ₹20,000 at 20%. Under the new regime, the entire gain of ₹2.25 lakh is taxed at 12.5%, leading to a tax liability of ₹28,130, an increase of ₹8,130 .
This change has prompted the AMFI to request the restoration of indexation benefits for debt mutual funds in the Union Budget 2025-26, arguing that the removal has adversely affected retail investors.
Conclusion:
Indexation in mutual funds in India enhances debt fund returns by slashing taxes for legacy investments. While recent changes have altered the tax landscape, understanding the implications of these changes is crucial for effective tax planning. Ready to optimize your portfolio? Explore more investment insights now!
– Ketaki Dandekar (Team Arthology)
Read more about Indexation in Mutual Funds here – https://groww.in/indexation