How does double indexation can save tax on debt mutual fund returns?
Do you know how an investment in debt mutual funds for short term of a year can zero your tax liability? There is a small idea which Investors use here and save tax which is called double indexation.
What is double indexation?
Double indexation would come into picture if you invest in first financial year and sell them in 3rd financial year. This would work well say, when you invest in Mar-2013 and sell them in Apr-2014. You are purchasing in Mar-2013 which is financial year 2012-13 and selling them in Apr-2014 where the financial year is 2014-15, hence you get a benefit of double indexation.
How this double indexation works?
Let me explain this with an example.
- You are investing in Debt mutual funds for Rs 10,000 in Mar-2013.
- Now in debt mutual funds assume you got a return of 10% in 13 months i.e. by Apr-2014. Your investment is grown to Rs 11,000 with a profit of Rs 1,000.
- The long term capital gain would be 10% on profit or 20% after indexation whichever is less.
- Assume that the cost inflation index (CII) in financial year 2012-13 is 852 and inflation is assumed at 7% p.a., the CII index for FY 2013-14 would be 911 and FY2014-15 is 975. If you are redeeming your mutual funds in Apr-2014, you can take into account the CII index of 2014-15, your investment of Rs 10,000 with double indexation would be Rs 11,437. Beyond this, you should pay long term capital gain tax of 20%.
- However your actual investment value in Apr-2014 is Rs 11,000 which shows that you have zero tax to pay and have a loss of Rs 437 which can be carried forward and set against future loss for next 8 years.
Would this work for debt mutual funds only?
There is no guarantee in other mutual fund categories that you would make money within short period of 1 year. However the other scenaior is that in one year where there is a bull run, you may make more money and it may cross the investment portfolio indicated which we computed with CII of FY 2014-15. However fixed income mutual funds like debt mutual funds, you can definitely gain as the returns are moderate.
You can benefit more when the interest rates are falling:
Several investment gurus are expecting that interest rates would fall in next few months. The first group of investors who would benefit when interest rates are falling are, investors of debt mutual funds. When interest rates are falling, bond rates and rates on other debt related instruments would increase.
Conclusion: If anyone is seriously interested to invest in Mar-2013 in debt mutual funds for a short term of 13 months, they can gain more, one way is through double indexation and other way is on account of fall of interest rates which benefits the debt mutual funds.
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How does double indexation save tax on debt mutual fund returns