The process of indexation involves adjusting an asset's purchase price to reflect inflation between the time it was purchased and sold. Since that too may sound slightly tricky, let us simplify it for you with an example:
Suppose you bought a home for Rs. 10 Lacs five years ago. Over the years the price has shot up to Rs. 12 Lacs. Now you intend to sell the home and the new buyer paid you Rs. 15 Lacs to reserve the home immediately. Here, you made a profit of Rs. 5 Lakhs (Rs. 15 Lacs – 10 Lacs) from the transaction. But for taxation purposes, the government allows you to adjust your purchase price to mirror inflation. A higher purchase price means lesser profits, which effectively means a lower tax. In our example, if you were to buy the same home today, it would cost you Rs. 12 Lacs. Thus, your profit/gains for taxation purposes will be Rs. 3 Lacs (Rs. 15 Lacs –Rs. 12 Lacs). You can see that due to the benefit of indexation, your taxable gains decreased from Rs.5 Lacs to Rs.3 Lacs, which would also decrease your tax liability.
While investing for the long term, most of us often focus on just the returns earned, ignoring the effect of taxation. In reality, what we should focus on are the post-tax returns. If there’s one major USP in debt mutual funds, compared to fixed deposits from a taxation perspective, it’s the indexation benefit.
Let us understand a few terms you should know to arrive at indexation:
Also, let us take a look at the taxation aspect of Bank fixed deposit (FD) and Debt Mutual Funds:
A bank FD is taxed during the course of the investment wherein interest from your bank FD is added to your income for every financial year. The rate of tax you pay on your FD interest depends on the tax slab which you fall into. So, if you are in the 20% tax bracket, you will be paying 20% tax on FD interest. Likewise, if you’re in the 5% tax bracket, it will be 5% on the FD interest earned.
On the other hand, a debt mutual fund is taxed only at redemption. This means that you pay tax on the capital gain only when you sell your debt fund units. If the debt mutual fund is sold in less than 3 years, the capital gains are added to your income and thus taxed at your slab rate. Therefore, they are similar to FDs in short term i.e. less than 3 years.
However, if your debt fund units are sold after the completion of 3 years, you pay 20% tax on your capital gain regardless of your tax slab rate and get indexation benefits i.e. you are allowed to inflate your costs (using Cost Inflation Index) to bring it to the current value of money. This helps you drastically cut down on tax outgo, thereby improving your post-tax returns.
How it works:
Suppose you are in the 30% tax slab and invest Rs. 1 lakh each in a debt mutual fund scheme and Bank FD in August 2017 (FY 2017-18) at the interest rate of 6%. After 3 years, in September 2020 (FY 2020-21) you redeemed your investments and received Rs. 1.19 Lakh. So your interest earned / capital gains amounts to Rs. 19,000.
Since you held the debt mutual fund investment for a period of more than 3 years, you will get the benefit of indexation and pay tax at a flat 20% rate, irrespective of your tax slab. In order to find the taxable gains after indexation benefit on Debt Fund returns, the original purchase price is adjusted for inflation using CII. The formula that is used is
Inflation-Adjusted Purchase Price = Actual Purchase Price X (CII in the year of sale/CII in the year of purchase)
In this case, the taxable capital gains after indexation benefit will be calculated as under:
As you can see, due to the benefit of indexation, your tax payable was reduced by Rs. 4,000 in case of the Debt Mutual Fund. But here, we are only looking at the difference between debt mutual funds and fixed deposits (FDs) based on the taxation perspective. So this should not be the sole reason to think about investing in debt mutual funds.
Points consider when investing in Debt Mutual Funds:
A debt mutual fund portfolio comprises of diversified instruments ranging across varying maturities and may include Commercial deposits, Commercial papers, Treasury bills, corporate deposits, etc. These underlying instruments are rated by credit rating agencies. However, bank fixed deposits are offered by just one entity, i.e. banks. Thus, the credit quality of the fixed deposits cannot be compared with that of debt mutual funds.
Debt mutual funds react to changes in the interest rates in the market. If the interest rate goes down, debt funds benefit and if the rates go up, they tend to lose. It is more beneficial to invest in debt funds in a scenario where you foresee interest rates staying steady or going down. So, while debt funds can offer relatively lower returns when interest rates go up, fixed deposits offer implied lower returns. Confused? Here’s another example:
Suppose you invest in a Fixed Deposit (FD) with a maturity of 5 years offering 7% per annum. This means, you’ve locked in your money at 7% per annum for the next 5 years. But what if the interest rate rises by 1% after a year? While new FDs will offer returns of 8% per annum, you’ll continue to get 7% per annum till maturity. Thus, you will have an implied opportunity loss of 1% p.a. for the next 4 years.
If you are not looking for regular cashflows, then debt funds could be your ideal investment choice over fixed deposits. However, if you need regular cashflows at pre-defined frequencies, say quarterly, annual, etc. then fixed deposits can offer you the same via their fixed interest payments.
Now that you know the different aspects to bear in mind while choosing between debt funds and fixed deposits, let’s challenge a common belief.
While fixed deposits have been the preferred investment choice for some time; it is prudent to give debt mutual funds a chance because, though FD interest rates are fixed, they carry the risk that the rate of inflation will be higher than the fixed deposit rate. If that happens, despite earning fixed returns, your money may grow but its value, may not.
So what are you waiting for?
Disclaimer: Investments in Mutual Funds are subject to market risks. Please read all the related documents carefully before investing.