Smart Investing Can Lead To Higher Net Returns Through Indexation

Indexation is meant to help investors tackle the impact of inflation on their investments, though it can help save more tax.

<div class="paragraphs"><p>Planning mutual fund investments only on past returns is a strategy that can backfire. (Source: Joshua Mayo/Unsplash)</p></div>
Planning mutual fund investments only on past returns is a strategy that can backfire. (Source: Joshua Mayo/Unsplash)

Indexation is the benefit that taxpayers get for the inflation that they face, and this results in a lower tax impact for them at the end of the day.

Though the concept is meant to help investors tackle the impact of inflation on their investments, it can also be an opportunity to generate additional tax savings. Looking at debt-oriented mutual funds in the last few weeks before the end of the financial year can lead to an extra amount being tax-free when these are sold after a period of three years.

Here is how this works:

What Is Indexation?

Investors face different kinds of challenges while investing, and one impact that is seen is that of inflation. The tax authorities have a special provision in place called indexation, whereby investments on which long-term capital gains are applicable, excluding equity shares and equity-oriented mutual funds, can increase the cost of their investments to account for the inflation they face.

This is facilitated through an index number called the Cost Inflation Index that is announced by the tax authorities every year.

For example, a debt mutual fund bought in January 2018 for Rs 10,000 and sold in March 2022 will have its cost increased to Rs 11.654 (10,000 x 317 ( index number of the year of sale)/ 272 ( index number of year of purchase)). This reduces the tax impact of the final gains and is hence beneficial for the investor.

Why Is March Extra Beneficial?

The indexation benefit is calculated for the financial year and is used only for long-term capital gains. In the case of a debt mutual fund, long-term capital gains are applicable when the fund is held for a period of three years or more.

When it comes to the month of March, holding the debt fund for a period of three-year-and-one-month will actually get the benefit of indexation for a period of four years instead of three. This is because the sale of the fund after the third year is complete will fall into the next financial year when this is made in April or thereafter.

For example, consider a debt fund bought in March 2020. If this is sold in April 2023, then the holding period of the fund is 3 years and 1 month. When it comes to the benefit of indexation, they will have the cost raised by 4 years, CII from 2019–20 to 2023–24, since the sale will be considered to have been done in the financial year 2023–24. This is why investing in March is a big advantage if you take an extra indexation of one year.

How Can One Make Use Of This Benefit?

There are enough opportunities that an investor can make use of this in a situation where one is considering debt mutual funds.

Fixed maturity plans are a good way to benefit on this front, and usually at the end of March there are a slew of launches by mutual funds of such FMPs for a period of slightly more than three years. The use of FMPs eliminates the interest rate risk in the debt mutual fund because the FMPs will select instruments that will mature along with the duration of the fund.

There are other options too, in the form of target maturity funds that are maturing in the few months after April 2026 and that will experience the same kind of situation of eliminating interest rate risk if held to maturity. On the open-ended side, there are banking and PSU debt funds plus dynamic bond funds that can be used. These funds will carry an interest rate risk, but with yields high and the expectation that the Indian economy is close to the peak of the rate hike cycle, the coming few years can turn out well.

Overall, the investor needs to have a clear strategy for making use of the indexation benefit, along with an understanding of the risk. Higher returns from debt on a net basis can prove to be a boon because it will raise the overall return of the portfolio.