Debt mutual funds offer investors an alternative to low-risk, fixed interest bank accounts. The main advantage of these funds is the ability to profit off increases in value: this phenomenon is known as capital appreciation.
The other main benefit of debt funds is that it cushions you against inflation risk. This phenomenon is known as indexation benefit and when used in mutual fund calculations, this allows investors to inflate their purchase price on a later sale date to reflect the true value of their purchase. So they may end up paying lower taxes because of this difference between original
All forms of income through debt funds are subject to taxation as per the Income Tax Act of 1963. However, the tax liability on dividend returns of such funds is not levied on investors directly. Instead, they are paid by the asset management company themselves. 29.13% dividend distribution tax is payable on total earnings of these mutual funds whereby 25% will
Profits earned from NAV units that are sold in the stock market are chargeable for tax purposes, but the rate depends on how much income an investor makes. For instance, if a debt fund is sold before three years then all earned profits will be taxable at the rate of thirty-five percent which is dependent on the annual income of an individual.
The short term capital gains tax has a range of 10% to 37%, depending on the section in which an individual falls under.
However, once a debt fund is held for more than three years, its gains are taxed at long-term capital gains rates (as high as 22.9%) in two ways.
|Gains||Eligibility criteria ||Tax rate |
|Capital gains at a short term|
The investor held the property for less than 3 years.
|For an individual's annual income|
|Capital gains made over a longer term||Mutual funds with a NAV of three or more years provide better growth than those held for less than three years.||Depending upon the income of an investor (with indexation), capital gains are taxed at a rate of 20%.|
However, in case an investor incurs capital loss during the sale of NAV units of debt mutual funds, it is exempted from income tax calculations for the respective financial year.
What is the purpose of indexation?
In mutual funds, indexation is the process of accounting for inflation to make your debt fund gains last longer and pay less taxes.
In May 2018, the value for one dollar was Rs 67. Currently, the value of one dollar is around Rs 76 - a jump of 13.5% from 67 levels to 76 levels shows how inflation has increased our purchasing power and decreased our capital's worth.
Indexation can benefit you by letting you claim tax deductions beyond inflation to cover the difference in value from when you bought your assets and when you are selling them. As a result, less income tax will be deducted from your returns.
The CII is the declared by the Central Board of Direct Taxes (CBDT) each year to determine what could be a more accurate value for your returns. The following formula can be used:
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The actual value after indexation can be calculated by multiplying the original amount with (the CII of the current year divided by the CII of the purchasing year).
For a better understanding, let us imagine an example. In 2014: Mr. X invested 1 lakh in debt mutual fund and 4 years later in 2018; the value of his investment was 80 thousand more than he originally had started with, that is 1.8Lakhs.
However, interest from debt funds is classified as income and taxed accordingly.
If no adjustments are made for indexation, a 10% tax is deductible. Let's assume the total annual income of the investor is Rs. 1 Crore. In that case, a person would have to pay taxes up to Rs. 10 Lakhs or so on an investment amounting to Rs. 90 lakhs only if there are zero
Tax = tax rate * total profit
= 10/100* 80,000
= Rs. 8,000
Consequently, his total profits will be Rs. 72,000 after deducting a total of Rs. 8,000 from the total amount he would have made if there had been no tax levied for trading in shares at 10%.
If inflation over the last four years were considered, then the Core Inflation Index in India has increased from 240 to 280 points.
To determine the value of your investment, use the indexation formula:
Inflation-indexed worth = 1,00,000 * (280/240) = Rs. 1,16,666.67.
Therefore, total gains realised = Redemption Value-Indexed Cost
Rs (1,80,000-1,16,666.667)= Rs 63,333.33
This value is subjected to a tax deduction of 20% of its value.
Tax payable = 20/100 * 63,333 = Rs. 12,666.67
Total realisable profit= Redemption value-Tax payable
Rs (80,000-12,666.67)= Rs 67,333.33
Indexation calculates your taxes on debt funds so that you are only taxed for gains and not how much of the initial value of the investment you have actually received.
As a result, with indexation:
- You receive Rs 67,333 in profit after taxes.
- Without indexation:
- You receive Rs 72,000 in
People who are in higher tax brackets, and would thus be attracting more income tax, have a lower profit from their debt funds without indexation than those being taxed at the same rate as the fund's projected growth.
To calculate the indexation benefit and check which system fits you best, do the appropriate due diligence. You may never know what you're overlooking. The calculation depends on various factors, including tax bracket and income level.
Conventional savings schemes, such as fixed deposits, do not receive indexation benefits. Thus tax payable on those earnings are higher compared to other types of savings which makes it a less attractive option for investors countrywide.
An indexation calculator or standard calculator can both be used to determine your total tax liability. Taxation rates should include inflation consideration using a variable inflation factor (VIF) list while the other calculation is done with a set rate.
Comparing your total tax liability and profits under both these situations, you can easily decide under which method you want to pay your taxes. The choice will maximize the returns earned.
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