Indexation in mutual funds: Definition, calculation, and key benefits

In simple terms, “indexation” means adjusting the purchase cost of an asset to account for inflation over time. While indexation in mutual funds once provided certain investors with meaningful tax relief, it has been removed in recent tax reforms for debt mutual funds.

However, understanding what indexation is, how it works, and the benefits of indexation can aid financial literacy, whether you own some older holdings or any alternative assets.

Let us look at the indexation meaning, the indexation formula and relevant calculations, and how it used to benefit certain categories of mutual funds.

• Table of contents

• Indexation in mutual funds
• How to calculate indexation
• Calculation steps
• Types of indexation strategies
• Why it matters
• Cost inflation index basics
• Impact on debt funds

Indexation in mutual funds

Indexation is a way of adjusting the original price of an asset, like a mutual fund or property, to keep up with inflation. So, instead of using the price you paid years ago, it increases the effective purchase cost based on inflation. This means that when you sell the asset, your profit is calculated after considering inflation. This reduces the net profit, which helps lower the tax you need to pay on capital gains.

With regard to mutual funds, debt funds and hybrid funds with less than 65% equity allocation enjoyed indexation benefits on long-term capital gains tax. Investors who held their units for 36 months or more would therefore receive this benefit upon redemption.

However, this indexation benefit was removed for all debt fund investments made after April 2023 in the Union Budget. Further, the 2024 Union Budget removed indexation benefits on hybrid mutual funds with less than 65% equity holdings.

Also Read: How are gilt mutual funds taxed?

How to calculate indexation

Calculation of indexation typically involves:

Indexed Cost of Acquisition = Original Purchase Cost X (Cost Inflation Index of Sale Year ÷ Cost Inflation Index of Purchase Year)

This formula gives you the inflation-adjusted cost of acquisition – in other words, the indexed cost of acquisition.

Based on this capital gains are calculated as follows:

Capital gains = Sale Proceeds – Indexed Cost of Acquisition – Any applicable expenses

A higher adjusted cost meant a lower capital gain figure, thus reducing the final tax liability.

Calculation steps

• Identify purchase year: Find the relevant CII for that year.
• Identify sale year: Obtain the CII for that disposal year.
• Formula: Indexed Cost = Original Cost × (CII of Sale Year / CII of Purchase Year).
• Subtract: Gains = Sale Proceeds - Indexed Cost.
• Apply LTCG rate: Formerly, LTCG tax on debt funds after indexation was 20%. Check if any changes apply to your scenario.

Imagine you bought debt fund units in 2019 for Rs. 1 lakh when the relevant CII was 280. In 2022, you sold them for Rs. 1.50 lakh, and the CII for that year was 331. According to the indexation formula, your adjusted purchase cost becomes:

Indexed Cost = Rs. 1 lakh × (331/280) ≈ Rs. 1.18 lakh

Hence, your capital gains = Rs. 1.50 lakh – Rs. 1.18 lakh = Rs. 32,000, which is lower than the unadjusted gain of Rs. 50,000 (Rs. 1.50 lakh - Rs. 1 lakh).

The difference would have led to lesser taxable gain under old rules.

Types of indexation strategies

• Systematic holding: Investors held their portfolio for the long-term (36+ months) to fully utilise indexation where available.
• Tax optimisation: Redeeming units in years with higher inflation could increase the adjusted cost, thereby reducing capital gains.
• Portfolio rebalancing: Some investors scheduled rebalancing only after crossing long-term durations, thus maximising indexation-based savings.

Also Read: Long-term capital gains tax on mutual funds

Why it matters

While no longer applicable for many assets, it is good to have the knowledge of indexation for the following reasons:

• Long-term financial planning: Understanding indexation helps investors factor in inflation and make better long-term decisions.
• Tax planning for future investments: While indexation is scrapped for mutual funds, it may be reintroduced for some assets. Familiarity with the concept helps in adapting to future tax changes.
• Understanding taxable gains: Investors who know indexation can better understand how their capital gains are taxed. This knowledge is useful for calculating tax obligations on other assets.
• Historical perspective: Knowing how indexation worked in the past can help investors optimize returns. It gives insight into potential opportunities and tax planning strategies moving forward.

Cost inflation index basics

The Cost Inflation Index (CII) is published yearly by tax authorities to reflect inflation. Each year’s index typically edges up, mirroring inflation’s average effect. The ratio of sale-year to purchase-year CII modifies the cost base. If inflation has soared, the ratio becomes more favourable to the investor.

Impact on debt funds

For investors, the question may arise: Should you invest in debt mutual funds if indexation no longer applies to new units? Debt funds can still offer several benefits, which include:

• Return potential: Potential for reasonable returns (higher than some traditional avenues) with moderate risk.
• Liquidity: Debt funds are typically more liquid than fixed deposits.
• Diversification: Mutual funds are professionally managed and spread risk across various bonds or debt securities.

Conclusion

While indexation in mutual funds doesn’t provide the same benefits anymore, it remains an important concept in finance. Additionally, mutual funds - whether equity or debt - offer a range of possibilities beyond taxation alone, from professional management to diversification. So even without the benefits of indexation, carefully chosen debt funds can still potentially add value to your portfolio.

FAQs:

What is indexation in simple words?

Indexation is an approach for adjusting the purchase cost of an asset to allow for inflation when determining the long-term capital gains tax. It reduces taxable gains by recognising a portion of the price increase as what we call inflation gain, rather than genuine economic value creation.

Is indexation applicable on mutual funds?

Indexation used to be applicable to debt fund units held for more than 36 months. However, new tax changes in April 2023 have removed indexation benefits.

How do I calculate indexation?

Multiply your original purchase cost by the ratio of the Cost Inflation Index (CII) for the sale year over the purchase year. The difference between selling price and this “indexed cost” was your taxable gain.

What is the indexation rule?

Historically, it let you reduce capital gains by adjusting your acquisition cost for inflation. In India, debt mutual funds and certain other assets (e.g., real estate) qualified for indexation if held past a specified duration. But ongoing rule changes have restricted or removed these benefits.

Which assets are eligible for indexation?

Traditionally, many long-term capital assets—like real estate, gold, or older debt mutual funds—qualified for indexation. Now, indexation benefit has been removed for all assets. However, owners of property purchased before July 23, 2024, can still choose to claim indexation benefits under a grandfathering clause.