Inflation—or the general rise in prices—hits all of us. But did you know that you can use inflation as a tool in your mutual fund (MF) investments to your advantage? There is a benefit called double indexation that allows you to save taxes on the gains that you make on your MF investments. You can use this tool while investing in fixed maturity plans (FMPs). One of the main reasons why we typically see more FMPs during the last two months of a financial year is to enable investors to use the double indexation benefit. Here’s how it works.
How does it work?
Say, you invest Rs.1 lakh in a 14-month FMP today, in the month of February. This means that your FMP will mature in April 2014. Although the FMP’s tenor is just 14 months, it covers two financial years, one ending 31 March 2013 and the other ending 31 March 2014. Due to rising inflation, the government allows you to inflate your cost price once a year, every year. Since your FMP covers two financial years’ closing dates, you get to inflate your cost price of the FMP, twice. Note that indexation benefits are only available for long-term capital gains taxation, which is if you hold on to your investments for more than a year.
At an assumed yield of 11%, your FMP would yield Rs.1.13 lakh at the end of 14 months. Here you have two choices: either you pay 10.30% tax if you do not avail indexation benefits or a 20.60% tax if you avail of indexation benefits.
In our example, if you do not avail the indexation benefits, you make a gain of Rs.12,947 (Rs.1.12 lakh minus Rs.1 lakh). A 10.30% long-term capital gains tax (without indexation benefits) means that you pay a tax of Rs.1,333.
Instead of that, let’s assume you avail indexation benefits and inflate your cost price. So how would you do that? Every year, the the government releases the cost inflation index figure of the current financial year. Assume that your indexed cost price goes up 8% next year and by another 8% the following year (2014-15; the financial year in which you will sell your scheme). In this case, your cost price gets inflated—at least on paper—to Rs.1.17 lakh. Since the cost price is more than the sale price (Rs.1.12 lakh), you end up paying no tax. Typically, FMPs launched during the last fortnight of March offer double indexation (cover two financial years).
Which funds is double indexation applicable to?
Double indexation benefits can be availed of for all debt MF investments since long-term capital gains tax is imposed on these if you sell after a year. Since equity funds are exempted from long-term capital gains tax, double indexation benefits don’t serve any purpose for them.