Unlike FDs, there is no tax liability on capital gains in debt mutual funds until you redeem it. However, the tax liability for debt mutual funds are little complicated as it includes indexation.

How Does Indexation works?

Indexation is nothing but adjustment of your purchase price with respect to inflation. It means that if you take the benefits of indexation, then your purchase price will increase as per the inflation and hence your capital gain will be lesser and you will pay low taxes in this process. Let’s take an example to get a broader understanding –

Shakaal invested Rs 1 Lakh in debt mutual funds in February 2013 and with drew all his investments i.e. Rs 1.5 lakhs in May 2016. He is liable to pay long-term capital gains with indexation at 20%. In this case, his purchase value i.e. Rs 1 lakhs will be adjusted as per inflation.

The mathematical formula to inflate the purchase price is:

Indexed cost = (CII for the year of sale/ CII for the year of purchase) X (Cost of purchase)

CII stands for Cost Inflation Index where the base year is FY 1981-82.

Here the CII applicable will be for FY 2012-13 (Purchase Year) and FY 2016-17 (Sale Year).

CII for FY 2012-13- 852

CII for FY 2016-17- 1125

Indexed Cost= (1125/852)* Rs 1 lakhs

Therefore, indexed cost is Rs 1.32 lakhs

Hence, Long-term Capital gains= Rs 1.5 lakhs- Rs 1.32 Lakhs = Rs 18,000 is long term capital gain which will attract tax @20%.

The tax liability with indexation is 20% of Rs 18000 which is roughly equivalent to Rs 3600.

Whereas, if you did not use this method to compute taxes then your capital gains would be Rs 50000 which will attract tax @ 10%. Hence, your tax liability will be Rs 5000 which is greater than your tax liability with indexation.

Bottomline

Indexation helps in lowering your tax liabilities if your capital gain is not beyond a certain limit. Whereas, the tax liability is lower without indexation if your capital gains are substantially high. You should always calculate your taxes with both the options and choose the one which has a lower tax liabilities.