Indexation on Mutual Funds helps investors in long-term debt funds to save taxes. If you sell investments in debt funds after three years, the gains are treated as Long Term Capital Gains (LTCG). LTCGs are taxed at 20 percent with the indexation benefit. Indexation allows you to inflate the purchase price using cost Inflation index.
It is a prudent way of not losing money by way of taxes. It helps us in inflating the purchase price of the debt mutual fund meaning we can reduce our tax liability. Before we jump into the pool of indexation, it is important to know two concepts. Namely :
Inflation & Capital Gains
Inflation is the gradual increase in a product or service. Capital Gains refer to an increase in the value of an investment over a specific time frame.
Indexation benefit is available to Mutual funds also if those are sold after holding for long term of more than 3years.
Indexation is a prudent way to prevent draining of your debt fund returns by way of taxes. It helps you to inflate the purchase price of the debt mutual funds. In this way, you can lower your tax liability.
Taxation on Mutual Funds
- Tax-Saving Equity Funds
Equity-Linked Saving Scheme (ELSS) are the most efficient tax-saving instruments under Section 80C. These diversified funds invest in equity shares of various companies across market capitalization.
Equity-Linked Savings Scheme (ELSS) is a type of equity fund and the only mutual fund scheme which qualifies for a tax deduction of Rs. 1.5 lakh per annum under Section 80C of the Income Tax Act. An ELSS comes with a lock-in period of 3 years which means an investment made in it cannot be withdrawn before 3 years.
- Non-Tax Saving Equity Funds
Long-term capital gains (LTCG) on non-tax saving equity funds up to Rs 1 lakh is free of taxation. LTCG above Rs 1 lakh is taxable at the rate of 10% without the benefit of indexation.
- Debt Funds
Long-term capital gains on debt fund are taxable at the rate of 20% after indexation. Indexation is a method which involves factoring the rise in inflation from the time of purchase to sale of the units.
Indexation allows inflating the purchase price of debt funds to bring down the quantum of capital gains. You are required to add short-term gains from debt funds to your overall income. They are subject to short-term capital gains tax (SCGT) as per the income tax slab you fall under.
Securities Transaction Tax (STT)
A Securities Transaction Tax (STT) is applicable at the rate of 0.001% on equity-oriented mutual funds at the time of redemption of units. An investor is not required to pay STT separately as it is deducted from the mutual fund returns.