How to get Indexation benefit of 4 years in 3 years in Debt Funds?
It is true that you can get indexation benefits of 4 years in 3 years if you time your debt fund entry and exit smartly.
Sounds like a neat trick right?
Let’s see how to get indexation benefit of 4 years in 3 years in debt mutual funds.
This is often termed as the double indexation benefit for debt funds.
As per the latest taxation rules of debt funds in India, the long-term capital gains in debt funds are taxed at 20% with the benefit of indexation. And the long term is defined as a holding period of over 3 years. Now to adjust the purchase price (investment price) for inflation, the government notifies Cost Inflation Index (CII) for each financial year.
Further reading: How to get indexation benefit in debt funds (with detailed examples)
So how can you get the indexation benefits of 4 years in 3 years when you invest in debt funds?
Suppose you invest in a debt fund towards the end of a financial year, say in February 2020 and plan to remain invested for ‘about 3 years’. Now if you redeem the debt fund in April 2023, it will allow you to use 4 indexation adjustments (namely of Financial years 2020-21, 2021-22, 2022-23 and 2023-24). So by holding for 38 months, you get the benefit of one extra year’s indexation. Had you just redeemed in February 2023, that is in exact 36 months, you would have got only 3 years of indexation benefit. So you can time your debt redemptions like this if you want to optimize further.
Easy to understand right?
Now let’s take a more detailed example. Don’t worry. It will be very easy to understand as well.
First, we will see how indexation reduces tax in 3 years due to indexation. And then we will compare it with the scenario where you get 4-year indexation benefit in just little over 3 years.
Suppose you invested Rs 10 lakh in a good debt fund (read how to pick good debt funds) in March 2015. The value of your investment after 3 years, i.e. in March 2018, has become Rs 12 lakh and you want to sell it.
Mathematically speaking, you made capital gains of Rs 2 lac, i.e. Rs 12 lakh – Rs 10 lac. That’s your actual profit or capital gains. But this gain was made over a period of 3 years (which qualifies as Long Term Capital Gains). And as per the latest rules, the long-term capital gains on Debt Funds are taxed at 20% after indexation. So we first need to adjust the cost of acquisition of debt fund units for indexation.
The government regularly releases the Cost of Inflation Index (CII) which is used to index (or adjust) the cost of acquisition of the debt mutual fund units.
Using the CII number data, the following are known:
- Cost of acquisition = Rs 10 lac
- CII number for 2015-16, the year of purchase = 254
- CII number for 2017-18, the year of sale = 272
So the indexed cost price of acquisition is calculated using the formula:
Indexed Cost = Actual Cost * (CII of Sale Year / CII of Purchase Year)
And in our example, this comes out as follows:
= Rs 10 lac * (272/254) = Rs 10,70,866
And this means that the long term capital gains is calculated as follows:
= Rs 12,00,000 – Rs 10,70,866 = Rs 1,29,133 (~ Rs 1.29 lakh)
So you get taxed 20% on this amount of Rs 1.29 lakh (instead of the actual profit of full Rs 2 lakh without indexation). And this translates to:
LTCG tax of 20% on Rs 1.29 lakh, i.e. Rs 25,826 (approx.)
Had it not been for the indexation benefit, your tax would have been 20% on full actual profit, i.e. 20% of Rs 2 lac = Rs 40,000.
So the Indexation technique has reduced the capital gains from Rs 2 lakh to Rs 1.29 lakh, which in turn lowers the tax from Rs 40,000 to Rs 25,826.
Now comes the trick to get 4 years indexation in just 3 years.
Suppose instead of selling in March 2018, you wait for one more month. That is you sell in April 2018. For simplicity, assume that the value of investment remains Rs 12 lac (like it was a month back in March 2018).
But April 2018 is part of a new financial year, FY 2018-19. So now the calculation of capital gains and taxes changes accordingly due to the addition of one more financial year.
Using the latest CII number data again, we have:
- Cost of acquisition = Rs 10 lac
- CII number for 2015-16, the year of purchase = 254
- CII number for 2018-19, the year of sale = 280
So the indexed cost price of acquisition is calculated using the formula: Indexed Cost = Actual Cost * (CII of Sale Year / CII of Purchase Year)
And in our example, this comes out as follows:
= Rs 10 lac * (280/254) = Rs 11,02,362
And this means that the long term capital gains is calculated as follows:
= Rs 12,00,000 – Rs 11,02,362 = Rs 97,638
So you get taxed at 20% on this amount of Rs 97,638 (instead of the actual profit of full Rs 2 lakh without indexation). And this translates to:
LTCG tax of 20% on Rs 97,638, i.e. Rs 19,527 (approx.)
So this is how it compares:
- If you buy in March 2015 and sell in March 2018 (in 3 years), you get indexation benefit of 3 years and your capital gains tax is Rs 25,826.
- If you buy in March 2015 and sell in April 2018 (in little over 3 years), you get indexation benefit of 4 years and your capital gains tax is Rs 19,527.
The above example illustrates how debt fund investors can avail ‘four’ (4) years indexation benefit if they invest for a little more than 3 years. This can be easily achieved if you invest in March (in year 1) and exit in April (year 3).
This is what is commonly referred to as the benefit of Double Indexation in debt mutual funds. So let’s say if you invest in debt funds in March 2021 and sell it in April 2024, you will have invested for 36+1=37 months but you will get double indexation benefit of 4 years, i.e. FY 2021-22, 2022-23, 2023-24 and 2024-25.
This is another reason why Fixed Maturity Plans (FMP) are generally launched during the last quarter of a Financial Year. They get an additional year of indexation. But this can easily be done using simple debt funds as well by investing in last month or so of a given financial year (as detailed in post above).
Availability of indexation (after 3 years) is what gives debt mutual funds an edge over the traditional bank fixed deposits. And when it comes to post-tax returns, debt funds are a good alternative to bank FDs. Do read how bank FD is taxed to get the full picture.