Sunday, January 20, 2013

Save Your Money : How indexation benefits you

To neutralize the negative effects of inflation on investors, the government has provided for a system called indexation in the Income Tax Act. It allows investors to use the rate of inflation to reduce their tax liability from the returns they get from their investments in debt mutual funds and bonds. The lower tax burden is commonly called indexation benefit, and under the IT Act, you as an investor can claim such benefits if your investments were held for more than 12 months.

Since, under the income tax rules, more than a year means long term, for capital gains accrued over more than a year you have the option to pay tax at the rate of about 10.30%. On the other hand, if you plan to use indexation, you would have to pay at the rate of about 20.60% on the capital gains after indexation. The amount of tax that is lesser when calculated using both the methods, is to be paid by the investor.

The idea of indexation
The idea behind indexation is that the purchase price of the investment should be linked to the rate of inflation during the holding period, and then only the earnings over and above the inflation-adjusted cost of acquisition should be taxed. What this process does, in a number of cases, is reduce the tax outgo for the investor.

Indexation benefits
Suppose you invested Rs 10,000 in the debt scheme of a mutual fund in fiscal 2008 and you have stayed invested in it for four years, till fiscal 2012. When you redeemed your units, you got Rs 15,000, which means a long term capital gain of Rs 5,000. If you want to pay directly, at 10.30% rate of tax without indexation, your tax burden is Rs 515.

Now suppose, rather than paying tax at the flat rate of 10.30%, you want to use indexation benefits for the gains from your investments. The government publishes cost inflation index to calculate indexation. Say for fiscal 2008, the relevant number was 575 and for fiscal 2012 it was 750. The formula for calculating the inflated cost of acquisition is:
{Purchase price x (index for fiscal 2012/index for fiscal 2008)}
By this calculation we have:
{Rs 10,000 x (750/575)} = Rs 13,043
Now the actual value of your
investment is Rs 15,000. So the taxable part would be:
(Rs 15,000 - Rs 13,043) = Rs 1,957

Now if you have to pay tax at the rate of 20.6%, then your tax outgo would be Rs 403.

In the first case, without indexation benefit, your tax outgo would be Rs 515. In the second case, with indexation benefit, your tax outgo is about Rs 403. So by taking advantage of the indexation benefits, your tax burden on your debt fund investments is reduced by Rs 112. Now, if your initial investment in the same debt fund was Rs 1 lakh, the savings would be Rs 1,120 and if it was Rs 10 lakh, the savings would be Rs 11,200.

Other issues
This indexation method, however, could result into higher tax outgo if the rate of inflation remains low during the holding period. And in cases where the rate of return in the debt fund is equal to the rate of inflation, there would be no tax burden on the investor.

A similar situation was observed recently in India. For a major part of fiscal 2012, fixed maturity plans (FMPs) gave annual returns of about 9% or more. And during the same period, the rate of inflation was also hovering above 9% or more. Given this situation, investors need not pay any income tax and can pocket the full gains from the FMPs.

To claim indexation benefits, you should remember that this is applicable only in case you have long-term capital gains from your investments in debt mutual funds,gold and real estate, the assets where other tax sops are not available. For example, if you invest in an equity mutual fund and held it for more than a year, you qualify to pay no taxes on those gains since such gains would qualify for long-term capital gains from investments in securities which in turn is not taxable.

The onus of calculation of indexation benefits, and to decide whether to pay income tax with indexation benefits or without, is the responsibility of the investor, that is you as a taxpayer. So if you are not very conversant with the calculations of taxes and indexation benefits that can accrue to you in your investments in debt mutual funds, gold and/or real estate, it is better to seek help from a person qualified to handle the same for you. Here, you should also remember that when you redeem your debt fund units, the money will come to you without the fund house deducting any TDS (tax deducted at source).

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