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How Indexation Helps Save Taxes on Capital Gains From Mutual Funds

Summary:

Indexation in mutual funds is a handy financial method which helps tackle tax liabilities. This blog explains how investors with long-term horizons can reduce taxes on capital gains from mutual funds.

Introduction to indexation of mutual funds:

Indexation in mutual funds is a handy financial method which helps tackle tax liabilities. When mutual fund units are sold, investors need to pay tax on capital gains. This is where indexation comes into the picture.

In the scenario of debt mutual funds, indexation takes into account the effect of inflation on the investment. It makes adjustments to the purchase price of the investment by utilising the cost inflation index (CII) that the government publishes. Through this, adjustments are made for the increase in overall price levels of goods and services over time.

When calculations are being done to arrive at the tax liabilities for capital gains, indexation assists in factoring in the eroding impact of inflation on the real value of the investment. It can be likened to an invisibility cloak that works against unnecessary or excess taxes which make the gains appear less than what they might actually appear to be at first glance.

The method of indexation is perceived to specifically useful when it is used for long-term investments (usually for periods in excess of three years). This is simply because it often results in a reduced taxable amount, which potentially saves the investor money. It's a smart technique to navigate the tricky terrain of tax on capital gains and helps the investor keep more of their earnings.

Advantages of indexation in mutual funds:

Indexation ensures that the investor gets more from their returns, but it also has some advantages, some of which are as follows:

Disadvantages of indexation in debt mutual funds:

Even though indexation in mutual funds, especially for debt funds, has a number of advantages, it does have some drawbacks, such as:

Summing up

However, indexation continues to be a valuable technique for investors, especially those who have long-term investment horizons in debt funds. Weighing the pros and cons depending on individual financial objective, strategy and the existing tax and economic conditions help with the effective use of indexation. Also, taking the help of an experienced financial advisor helps to use indexation accurately for lowering taxes on capital gains.