How Indexation Increases Debt Fund Returns

Debt funds witnessed an increasing level of interest amongst retail investors when FD rates plummeted to multi year lows post the COVID induced rate cuts in 2020. While it’s a fact that debt funds have the potential for delivering higher absolute returns that fixed deposits, did you know that they are more tax efficient in the long run as well? Indeed - if you hold your debt fund units for more than three years, you can reap the benefits of “indexation”.

How Indexation Works

Simply put, indexation reduces your ‘taxable’ profit booked when you sell your debt fund investments after a minimum of 3 years (although there’s no lock-in period involved). Every year, the income tax department of the Government of India releases a number called the “Cost Inflation Index”. A few years ago, the “base year” for this index was revised from 1980 to 2001. For the fiscal year 2022-23, the number stood at 331. It’s quite simple, really – when you redeem your debt mutual funds after three years, the income tax department allows you to adjust the purchase price of your units by the change in Cost Inflation Index in the time period between the year of purchase and the year of sale. By “increasing” the purchase price, your “indexed” profit reduces – and so does your tax liability!

An Example

Let’s illustrate indexation with a simple example. Shyam invests Rs. 100,000 in a debt fund on 1st May 2019 and redeems Rs. 136,000 in July 2012. Since he’s held on to his units for more than three years, indexation will apply.

From the IT department website, Shyam learns that the Cost Inflation Index was 289 in the fiscal year 2016-17 (his year of purchase) and 331 in 2018-19 (his year of sale). That is, the index has grown by 14.5% in this time period.

What Shyam can now do it “index” his purchase price by 10.23% - that is, consider his buying cost to be Rs. 114,500.  This would bring down his taxable profit from Rs. 36,000 to Rs. 21,500. Moreover, he would be required to pay a tax of 20% on this indexed profit. This works out to Rs. 4300 (around 12% of the booked profit). Had Shyam earned this profit from a fixed deposit, he would have had to pay more than Rs. 12,000 in taxes (assuming he’s in the highest marginal tax bracket). In this manner, debt mutual funds can be very tax efficient for holding periods exceeding 3 years, and for individuals who are in the highest tax bracket.