How to Calculate Your Tax Liability in Debt Mutual Funds with Indexation?
One of the benefits of debt funds is that it cushions you against inflation risk and this phenomenon is known as indexation benefit.
Indexation benefit calculation allows you to inflate your purchase price. This compensates you for inflation. So when you sell your fund on a later date, indexation benefit will allow you to inflate your purchase price on that date to reflect the true value of your purchase. You may end up paying lower tax on debt mutual funds. Indexation in mutual funds is allowed only in the debt fund category.
How Much Is The Tax Liability on Debt Mutual Fund Earnings?
All forms of income through debt funds are subject to taxation as per the Income Tax Act of 1963. Tax liability on dividend returns of such funds is not levied on investors directly.
Dividends received from mutual funds or after April 1, 2020 is taxable in the hands of the investors. The tax rate is dependent on the income tax slab the investor falls in.There is also a TDS on dividend distribution by mutual funds from the same date. This is how debt fund taxation is done.
Capital gains made through the purchase and sale of NAV units in the stock market are also taxable. They are known as capital gains.
In debt mutual fund taxation, if the debt fund was sold before three years, it is known as short term capital gains. The total profit earned is taxable depending on the annual income of the investor.
However if the debt fund is held for more than three years, the it is known as long term capital gains. LTCG tax on debt mutual funds is levied in two ways:
- With indexation benefits: 20%
- Without indexation benefits: according to the income of the investor
Tax on Capital Gains on Debt Mutual Funds
| Type of Gain | Eligibility criteria | Tax rate |
| Short-term capital gains | Security was held by the investor for less than 3 years | As per the annual income of an individual |
| Long-term capital gains | A possession time period of the NAV units of debt mutual funds should be more than three years | Depends upon the income of the investor (without indexation)
20% (with indexation) |
However, in case an investor incurs capital loss during the sale of NAV units of debt mutual funds, it is exempted from income tax calculations for the respective financial year.
What is Indexation?
Indexation is basically the process by which you account for inflation in your debt fund gains so that you pay fewer taxes.
We all know the value of rupee goes down over a couple of years and is the best way to look at indexation. While in May 2018 the value for one dollar was around Rs 67, the value for one dollar is around Rs 75 levels around October 2021. This 13-14% jump from 67 to 75 is an embodiment of inflation and how it has reduced our purchasing power.
Indexation benefit seeks to give you returns over and above this inflation. If you inflate your purchase price according to the ongoing inflation rate, the gap between your sale and purchase price will reduce and you will pay lower taxes.
Indexation Calculation for Debt Funds
The total adjustment of capital gains depends on the cost inflation index (CII) declared by the Central Board of Direct Taxes (CBDT) every year. The real value of profits can be determined by using the following indexation formula –
Actual value after indexation = original amount * (CII of the current year/CII of the purchasing year.)
Let us demonstrate this with an example. Mr. X had invested Rs. 1 Lakh in a debt mutual fund in 2014. Four years later, he decides to redeem his investment at Rs. 1.8 Lakh in 2018, thereby realizing a profit of Rs. 80,000.
The nominal value of investment realized can be determined by the indexation formula –
Actual purchase value after indexation = original amount x (CII of the current year/CII of the purchasing year)
In 2014, the CII of India was 240. In 2018, the value increased to 280.
Inflation-indexed worth = 1,00,000 * (280/240) = Rs. 1,16,666.67.
Therefore, total gains realised = Redemption Value-Indexed Cost
Rs (1,80,000-1,16,666.667)= Rs 63,333.33
This value is subjected to a tax deduction of 20% of its value.
Tax payable = 20/100 * 63,333 = Rs. 12,666.67
Total realisable profit= Redemption value-Tax payable
Rs (80,000-12,666.67)= Rs 67,333.33
Taxation without indexation benefit: The tax treatment of Rs 80,000, which is the capital gains in this example, will depend on the income tax bracket of the investor, if he/she decides to not opt for indexation benefit.
Final Words: Should You Go for Debt Fund Indexation Benefit?
You should do the due diligence in doing the indexation benefit calculation and checking which system suits you best. You may never know what you are missing out on. As we mentioned above, it depends on various factors, one of them being your income level and tax bracket.
Adjustments for indexation are not made in conventional savings schemes, such as fixed deposits. Thus, the tax payable on those earnings is considerably higher.
You can choose between the two options available while determining your total tax liability. Using an indexation calculator, the total tax payable can be determined when the inflation rate is considered, while tax rates without adjustments can be calculated through standard calculators.
Comparing the total tax liability and profits under both these situations, you can easily decide under which method you want to pay your taxes, thereby maximising the total returns earned.
Happy Investing!