Indexation is an important process in finance, especially if you seek to optimise your returns in some of the best trading platforms in India. This method adjusts the cost of purchase based on the inflation index released by the government every year.
For instance, if you invested in a mutual fund unit that offers indexation benefits at Rs. 100 in 2012-13 and sold it for Rs. 150 in 2018-19, with cost inflation indices of 200 and 280, respectively, the indexed cost of acquisition becomes Rs. 140. This is because inflation caused the value of Rs. 100 to drop. So, whatever you could buy at Rs. 100 back then, you would need Rs. 140 to buy it at present. Thus, the cost of acquisition becomes Rs. 140. Moreover, when considering 'tax rates post indexation,' taxable profits are calculated only above the indexation value, so you have a fair assessment of gains based on inflation.
How does Indexation work?
Indexation functions by considering inflation on the buying price. In mutual funds offering indexation benefits, this process becomes instrumental in providing a more accurate reflection of capital gains. By adjusting the buying price based on inflation indices, indexation protects investors from paying taxes on gains that are merely reflective of the decrease in the value of money over time. While investors earn a certain amount of profit from their mutual funds, inflation takes up a part of it. Indexation takes this into consideration and taxes investors only on the profits gained after inflation. This ensures a fair and equitable taxation system.
Benefits of Indexation
For mutual fund investors, this method shelters them against the impact of inflation, preserving the true value of their invested capital. By mitigating the tax burden on gains owed to inflation, indexation encourages long-term investment, enabling a more sustainable and profitable financial journey.
Indexation is calculated based on the Cost Inflation Index for a particular year. For the financial year 2023-24, the CII is 348. The CII is used to predict the increase in the price of a particular product/service. The financial year of 2001-02 is considered the base year for calculating indexation. So, the CII for 2001-02 is 100. It has been increasing every year since.