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Understanding Indexation in Mutual Funds and Eligible Schemes

When you sell mutual fund units, you are liable to pay capital gains tax on the profit earned. Capital gains tax depends on factors like the holding period and the type of fund. Indexation is a provision that comes into play while calculating the net tax liability on capital gains. It helps in reducing the profit gap between the purchase price and the sale price due to inflation.

To be eligible for indexation benefits, investors need to choose the growth option of the fund and remain invested for a minimum of 3 years. Indexation involves inflating the purchase price using the Cost Inflation Index (CII), a government-notified inflation factor. This inflation-adjusted purchase price reduces the total profit and, consequently, the capital gains tax liability.

For example, if an investor purchased mutual fund units in 2018 and redeemed them in 2023, the purchase cost can be indexed up with reference to the CII of 2023-24 divided by the CII of 2018-19. The tax liability is then calculated on the difference between the indexed-up purchase price and the sale price.

However, recent changes in the Finance Act of 2023 have impacted indexation benefits. Indexation benefits on debt mutual funds are no longer available. Gains from the growth option of a debt mutual fund with less than 35% equity allocation are taxed as Short Term Capital Gain (STGC) at the marginal tax slab rate, irrespective of the holding period.

Equity mutual funds, on the other hand, continue to enjoy favorable tax treatment. Pure equity funds with over 65% equity allocation do not qualify for indexation benefits. If an investor holds the growth option of an equity mutual fund for more than 12 months, they become eligible for Long Term Capital Gain (LTCG) tax, calculated at 10% plus cess and surcharge.

Some hybrid and multi-asset funds that allocate 35-65% to equity may be eligible for the indexation benefit, as per the Finance Act. However, investors should confirm with the fund house or a financial advisor whether a particular fund is eligible for indexation.

Please note that mutual fund investments carry market risks, and it is advisable to consult a SEBI-registered financial advisor before investing


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