Our investments are heavily affected by inflation. Assume you have opened a bank deposit offering you 6% interest for one year. Now while closing the deposit account, if the inflation is 8%, you actually end up losing 2% (8-6). It means your investment has lost its value. In order to protect the value of your indexation, you have to use the power of indexation.
“Inflation for the week ending July 26, 2009 is 0.17%” or “Prices of vegetables reach sky high” are some of the headlines that we come across everyday in our newspapers. So it becomes important for us to understand what inflation is and how it affects our life. It is also important for us to know how to beat this deadly killer.
Inflation and its effect on our lives
Assume the price of 1 kg of tomatoes is Rs 14. If after a month, the price of the same amount of tomatoes becomes Rs. 18, we can say the price of the tomatoes has gone up. This price rise is called as inflation. It is a deadly killer that erodes the value of money, as you are paying more for the same quantity of goods. But not only that, it also erodes the value of our investments and makes all the goods and services beyond the reach of the common man.
Effect of inflation on investments
Our investments are heavily affected by inflation. Assume you have opened a bank deposit offering you 6% interest for one year. Now while closing the deposit account, if the inflation is 8%, you actually end up losing 2% (8-6). It means your investment has lost its value. In order to protect the value of your indexation, you have to use the power of indexation.
Concept of inflation index
The indexation uses the concept that as the inflation erodes the returns from the investment; you should be made to pay tax only on the actual profit made on the investment. To help in calculation of the actual profit earned on the investment, the government has prepared an index known as the cost of inflation index. This index uses 1981-82 as its base, and its value is fixed to be 100. Now for each financial year, this value is declared. This gives you the choice of paying long-term capital gains at 20% along with indexation benefits. Alternately you can pay long-term capital gains tax at the flat rate of 10%.
Calculating capital gains
In order to calculate the profit earned on which the tax should be paid, the ratio of the inflation index when the sale occurs to its value when the purchase is made and is multiplied by the purchase price of the asset. It helps you calculate the indexed cost of acquisition, which is then deducted from the selling price. E.g. you bought an asset for Rs 100 in 2000, when the inflation index was 150. You sold it in 2005 when the inflation index was 300. The ratio of the inflation index when the sale occurred is 300/150 =2. The indexed cost of acquisition is Rs. 100 x 2 =Rs. 200. The capital gains here are Rs. 300 – Rs. 200 = Rs.. 100. This is the amount on which you will actually be paying tax. Since the indexed cost of acquisition is based on the ratio of the cost inflation index, while actually selling the asset, the tax you actually pay will decrease as this figure increases. As the time passes, the inflation also goes up, thus reducing the taxable amount. If the profit earned is very small, you may not actually have to pay any tax, as all your gains are offset by the rising inflation.
Benefiting from indexation
The most common methods of benefiting from indexation is to prolong booking profits, such that it spreads out over two financial years. This lets you enjoy the indexation benefit for 2 years in one shot. Also remember the indexation benefit can be enjoyed in instances where a long-term capital gains is obtained. Here debt mutual funds score over FDs and bonds, which attract the tax as high as 33%. Also the total income is taxed in case of bonds and FDs but in case of debt funds, it is only the profit is taxed. Also if you opt for systematic withdrawal plan, the total taxable income also reduces, as the capital decreases.
Inflation is a major destroyer of wealth, as it greatly affects your returns. To beat inflation, it is important to benefit from the power of indexing. It lets you reduce your tax liability after taking into account the inflation, and pay tax only on the actual gains you earned. Also remember, longer you remain invested, lower the tax you pay as inflation goes on increasing over the period of time. Besides choose tax-efficient investment options like mutual funds to reduce your tax liability and beat inflation.