How to save tax on gains of debt mutual funds?

Presently, people have started investing in mutual funds as they are getting aware of the benefits offered by MFs as their returns are better than traditional investment avenues and also offer tax efficiency, diversification, etc. Tax is an important factor that every investor should take into account before investing in any type of investment avenue as your returns get affected. For a detailed understanding of how different schemes of mutual funds are taxed, you can refer to:  https://www.dsij.in/DSIJArticleDetail/ArticleID/19498/ArtMID/10163/preview/true 

How Debt mutual funds are taxed?  

What does indexation mean and how can we benefit from the same:  

Investments with higher returns come with higher tax, which reduces your overall returns. Indexation here plays a vital role. It helps to reduce the taxation on your returns. It is only applicable to long-term debt instruments but it isn’t applicable on equity investments and bank fixed deposits interest as well. Indexation helps you in adjusting the purchase price of your investment by inflating them at the current value. For instance, you bought debt funds in 2015 at Rs 1,00,000 and now, your investment value is Rs 2,50,000 and you are planning to sell these debt funds. So, the purchase value of Rs 1,00,000 will be inflated at the current value as per the cost inflation index (CII) notified by Central Board of Direct Taxes (CBDT) and that inflated value will get deducted from selling value while the remainder will be taxed at the rate of 20 per cent.    

Formula of Indexed Cost of Acquisition = Original cost of acquisition * (CII of the year of sale/CII of the year of purchase)  

Illustration:  

Suppose, Mr A had bought 1,000 units of debt fund at Rs 100 in 2010 and now, his investment value is Rs 4,00,000. He wants to sell the same units, then what will be the tax amount Mr A will have to pay? 

Selling Price of debt funds = Rs. 4,00,000

Purchase Price = Rs. 100000 (1000 units*Rs.100)

Year of purchase = 2010, CII of year 2010 = 167

Year of sale = 2021, CII of year 2021 = 317

Computation of tax liability of Mr. A

Now LTCG is 2,10,179 and 20% tax will be applicable on this amount. Tax liability of Mr. A will be 42,035 (210179*20%).

If indexation benefit wasn’t available then tax liability of Mr. A would have been

As you can see there is significant difference in tax if indexation benefit is not considered. Tax saving due to indexation benefit is of Rs. 17,965 (60000-42035). This is how indexation helps investors in saving tax on long term debt investments. Investors should invest for the long term to get optimum benefits.