Indexation benefits: all you need to know

Indexation is a tax-saving tool that helps investors adjust the purchase price of their investments to account for inflation. It's particularly beneficial for long-term investments, especially those in debt funds. Before we learn what are indexation benefits, let us take a step back and ask ourselves, what is indexation?

What is indexation?

Inflation erodes the purchasing power of money over time. Indexation is a mechanism that recognises this and allows investors to adjust the purchase price of their investments to reflect the impact of inflation. This, in turn, reduces the taxable capital gains.

How does indexation work?

• Cost Inflation Index (CII): The government publishes a CII annually, which is used to adjust the purchase price of an asset for inflation.
• Calculation: The purchase price of an asset is multiplied by a factor derived from the CII for the year of sale divided by the CII for the year of purchase. This inflated purchase price is then used to calculate capital gains.

Benefits of indexation?

• Reduced Tax Liability: By increasing the purchase price, indexation effectively lowers the capital gains, resulting in lower tax outgo.
• Long-Term Investment Incentive: Indexation encourages long-term investing as the benefits increase with the holding period.
• Hedge Against Inflation: By adjusting for inflation, indexation helps protect the real value of your investment.

Conclusion

Indexation is a valuable tool for investors to mitigate the impact of inflation on their long-term investments. By understanding how it works and utilising it effectively, you can optimise your tax savings and enhance your overall investment returns.