If you invest in the growth option of an FMP for over a year, you pay either 10% capital gains tax without indexation or 20% with indexation. An investor can also take advantage of double indexation by investing in one financial year and then sell in the third financial year from then. It means you can buy in March of year 1 and then sell in April of year 3. This will virtually bring down the tax impact to a very low level if not to zilch. In other words, the whole yield on such investments becomes tax free. However, the actual tax advantage would also depend on which tax bracket you are in.

How does it work?

Suppose you invested Rs 1 lakh in an FMP in March 2013 (financial year 2012-13) and plan to sell your investment in April 2014 (financial year 2014-2015). The FMP has an average portfolio maturity of five years. Now, you will get accrued interest of approximately 9% on this investment. Now, as per current tax laws you have the option of paying tax on long-term capital gains with or without indexation. Assuming a 9% return per annum on your investment, your total fund value will be Rs 1,10,635 (investment 1,00,000 and a capital gain of 10,635) in April 2014.

Now the tax calculation would work as follows: The CII (cost inflation index) for the year 2012-13 is 852. Assuming 7% inflation, for the next two years, the CII for 2013-14 will be 911 and that for 2014-15 will be 975. If the FMP is redeemed in April 2014, you can also take into account the CII of 2014-2015. Capital gain with double indexation in this case will be Rs 1,10,635 - 1,14,437 = (-) 3,802. Thus, as per the calculation, you make a loss of 3,802. That means you will pay zero tax, or your returns are tax-free. In fact you can even carry forward this loss for eight years and can set it off against longterm capital gains.