In the plainest of terms, liquid funds are debt funds. The only difference between the two is that liquid funds, akin to their name, have a maturity period of just 91 days. Liquid funds invest capital in very short-term money markets and these have predetermined rates of interest. Instruments invested in can be government securities, treasury bills, commercial paper, etc. Consequently, such mutual fund investments hold risk which is minimal, and attract low-risk tolerance investors. Therefore, such funds are referred to as the debt funds with the least risk.
More Benefits
Liquid funds can give you higher gains than simple bank deposits can. Liquid funds are linked to the markets and hence, offer you high rewards. This is one of the main reasons that investors prefer these over and above bank deposits. However, before you deep dive into investing in liquid funds, taxation related to your investments must be considered.
According to the Income Tax Act, 1961, if you sell liquid funds within a 36-month period, or 3 years, you will need to pay a short term capital gains tax. Any returns that are generated through liquid funds are taxed as per the investor’s income tax bracket. In case you hold your liquid funds for over 3 years, your gains will represent long-term capital gains, which will extract a tax of 20% (with an indexation advantage).
The Taxation of Liquid Funds in Detail
In a similar way to investing in other types of mutual funds, investors can opt to invest in liquid funds for dividend or growth returns. Accordingly, the taxation varies, depending on your investment returns purpose.
Let’s say that a particular investor chooses the growth option for getting returns through liquid funds. In case investors redeem units of liquid funds before the stipulated 3-year period ends, then short-term capital gains tax is applied. Furthermore, the tax is levied according to investors’ tax brackets and gains are taken as part of investors’ incomes. In case investors opt for the redemption of units after 3 years, then long-term capital gains taxes apply. These taxes amount to 20% tax after indexation.
While investing with liquid funds, investors can choose dividend plans to get returns from the funds. These are paid out from time to time by companies of the securities that are held, when the company makes a profit and shares it with investors. Dividends offered through liquid funds (as your returns on investment) attract a tax. The dividend amounts are added to your total income, then taxed according to the income tax rate of the bracket you fall under.
Your Tax Bracket and Returns
Liquid funds hold many advantages over other financial instruments. Therefore, for a balanced and diversified portfolio, these funds, even after taxation occurs, give moderately good returns. Most experts will advise investors to go in for liquid funds for at least a part of capital allocation. The returns you earn with any liquid funds depend on the amount you invest, and your income bracket/tax slab. The way to earn more and get substantial gains out of liquid funds is to allocate more capital to funds, and you can do this in a gradual way. Instead of leaving funds idling in the bank, placing them in liquid funds will give you more bang for your buck.
There is always the option to place surplus funds in the bank in a regular savings account. If you want to avoid taxes, this is a good way to do so. Interest which is earned on a savings bank account, up to Rs. 10,000, is exempt from tax under Section 80TTA of the Income Tax Act, 1961. However, with this option, you tend not to earn much interest. The returns you’d get from liquid funds would be more than just those from savings bank accounts.
Let’s take an example of how liquid funds work according to the tax bracket you fall within. Consider a liquid fund with a 7% return. Actual returns after tax has been levied, will amount to 6.3%, 5.6%, and 4.8%, respectively, for those individuals belonging in the 10%, 20% and 30% tax slab. This is evidently higher than the interest you would get from a simple fixed deposit plan or a regular savings account interest. A few banks may offer you higher interest, at say, 5%, but even then, liquid funds earn you more. In case you fall within a higher tax slab, say, the 10% – 20% slab, you may choose to opt for growth liquid funds rather than dividend funds, since growth funds are taxed at a flat rate of 20%. In the case of individuals earning higher incomes overall, flat rates of taxation prove more fruitful than those that apply according to a specific income bracket.
The Purpose of Liquid Funds
The primary intention of liquid funds is to offer investors a great degree of liquidity plus safety in terms of the capital of investors. If these two things are achieved significantly well, a liquid fund is a better investment option for reaching goals for the short run.