understanding indexation and tax liability

when we make long-term investments we tend to focus only on the return on paper as our net gains and ignore the impact taxation has on these financial returns.

not all investment products are taxed the same. a fixed deposit or an equity scheme or a debt scheme, all these investment products are taxed differently. but to have better post-tax returns over the long term, investors can leverage the benefits of indexation.

why indexation matters

we know that inflation constantly eats into our returns, but is it taken to account while calculating taxes? this is where indexation comes in.

indexation helps adjust the purchase price of your long-term investments, including debt funds, against inflation. and hence it reduces the tax liability on your gains.

this is how it works. indexation references the government’s cost inflation index (CII), which is updated on the income tax website. it then adjusts the purchase price against inflation and the resultant price increases, and this leads to a reduction in profits and in turn taxes.

let’s see this with the help of an example. let’s say you invested Rs 1 lakh each in a fixed deposit and a debt fund for a period of 5 years. both the instruments generated returns at the same rate, let’s assume it to be 6%.

in the fixed deposit, your pre-tax returns come up to Rs 34,686 after 5 years. say if you are in the 30% tax slab, then the total tax payable on your gains would be Rs 10,405.

here is how indexation will play out for the debt fund. after 5 years the pre-tax gains are going to be the same as Rs 34,686, but the cost of purchase after indexation will be considered as Rs 1,25,415 (taking the investment period of FY15 to FY21). then, effectively,  your taxable gains come out as Rs 9271 (adjusted for inflation over 5 years) at the highest tax slab of 20%, the tax would come out to be Rs 1854.

this is how indexation helps plug tax leaks in one’s portfolio.