What is Indexation in mutual funds? 

It is a known fact that the purchasing power of money reduces over time. An Rs. 2000 note today will fetch lower value a year later and further lower a decade later. Similarly, a Rs. 100 item will most likely not be available at the same rate a year later and available at much higher rates 10 years later. This happens due to the increase in prices of raw materials, input services etc. In normal parlance, this is referred to as inflation, which reflects the increase in prices of commodities and services across different periods. Income tax laws also conceptualise this reality through the indexation benefit.

How are Capital Gains Calculated?

When it comes to calculating capital gains on mutual fund investments, the investor needs two primary inputs – the invested amount and the redemption value. The difference between these two figures represents the actual returns generated by the investors. Such returns are classified into Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG) depending upon the type of mutual fund scheme and the holding period. 

For equity-oriented funds, the specified period of holding for categorisation of capital gains as LTCG is 12 months. For other funds like debt funds, gold funds, etc., such a period is 36 months. As such, the gains from the mutual fund units held for less than 12 or 36 months in equity oriented funds or other than equity oriented funds respectively, the gains will be classified as STCG. For units with a longer holding period, the gains will be classified as LTCG. The tax rates also differ on different types of capital gains as summarized below:

What is the Indexation benefit?

Indexation refers to adjusting the cost of a capital asset, which is equivalent to the invested amount, to the prevailing inflation over the years. is notified by the Govt. every year to ensure uniformity in this regard. When the cost of investment is adjusted for inflation through Cost Inflation Index (CII), the effective taxable gains reduce to that extent. The Cost Inflation Index (CII) notified by the Govt. for different years is as under:

Source: incometaxindia.gov.in

Benefit of Indexation

With CII value being notified by the Govt. based on inflation figures over the years, the indexation benefit adjusted the value of an investment to calculate Capital Gains and effectively reduced the overall tax incidence on such returns by considering the impact of inflation over the years. The indexed cost of investment is calculated as below:

Indexed Cost of Investment = Invested Amount X CII for redemption year/ CII for the year of investment
 

Note: This article is for information purposes only. Indexation benefits are no longer available for debt mutual funds purchased on or after April 1, 2023.

Disclaimers: The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. In view of the individual nature of the tax consequences, each investor is advised to consult his or her or their own tax consultant with respect to specific tax implications arising out of their participation in the Scheme. Income Tax benefits to the mutual fund & to the unit holder is in accordance with the prevailing tax laws as updated for the Union Budget 2024 presented in the Parliament in February 2024. Further, the tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment. Any action taken by you on the basis of the information contained herein is not intended as on offer or solicitation for the purchase and sales of any schemes of UTI Mutual Fund. Please read the full details provided in SID and SIA carefully before taking any decision.

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