Liquid funds are a kind of debt mutual fund that invests in market instruments with a maturity period of 91 days or less. Government securities, treasury bills, and money market instruments are some examples of liquid funds. As their maturity period is short, they are associated with the lowest possible risks.
Also, they can be easily redeemed due to their unmatched liquidity.
However, unlike some other mutual fund investments, the NAV (Net Asset Value) of these funds changes frequently, even daily.
Short-term Investments: Why Liquid Funds?
Debt mutual funds offer an annual return of around 10% and, unlike equity funds, are less volatile and feature more liquidity; hence, an excellent way to park surplus funds.
Also, of all types of mutual funds in India, debt funds are more popular as they are non-traditional short-term investments that can offer up to 10% in annual returns.
Debt Funds: A Brief
Debt funds invest primarily in fixed-income and variable maturity instruments. There are various types of debt funds to cater to the varied needs of modern investors. In the Indian market, dynamic funds, liquid funds, accrual funds (credit opportunities funds), gilt funds and ultra short-term funds are available for investors. There are only two markers of difference in all of them – investment type and maturity period.
Why Liquid Funds?
Not only are Liquid Funds low-risk, they are the least volatile of all mutual fund classes. They invest only in those securities that have a high credit rating and the NAV changes over the interest the fund accrues. The NAV may change even every single day. Usually, investors don’t prefer trading liquid funds, as they have short maturities, further reducing any NAV-related volatility.
However, a word of caution
While savings accounts offer about 4% interest, the ROI for liquid funds is around 8- 9%, making it more attractive to those who wish to multiply their spare cash in a short time. But, this doesn’t mean that liquid funds are a substitute for savings accounts. You should never park all your savings and spare cash in liquid funds, as they rarely offer immediate withdrawal services like bank ATMs. Consequentially, you might get stuck in an emergency with empty pockets.
On the other hand, there are no exit loads in liquid funds, regardless of the time for which you’ve been invested in the fund.
There are two ways to liquidate the fund after maturity:
- As a lump sum – Withdrawing the entire fund with returns in one go.
- Through Systematic Withdrawal Plan (SWP) – A pre-decided portion of the units is redeemed in predefined intervals. The amount is credited to the investor’s bank account directly until the fund is exhausted
Tax on Liquid Funds
As a part of non-equity fund category, liquid funds are subject to the same taxation rules as other debt funds. As per the new income tax (IT) laws, debt funds are subject to short-term and long-term capital gains tax.
Short-term capital gain tax is calculated for investments that are held for less than 3 years and the investor liquefies them earlier. The return so earned is then considered a part of the investor’s annual taxable income and is taxed according to the IT bracket the investor falls in.
While taxable income up to Rs.2.5 lakh (annually) is exempt from tax, income between Rs.2.5 lakh and Rs.5 lakh is taxed up to 5% and tax of 20% is applicable on annual income between Rs.5 lakh and Rs.10 lakh.
However, if the units of a liquid fund are held for more than 3 years, Long Term Capital Gains (LTCG) rules will be applicable. Even in case the SWP of these liquid funds lasts for more than 3 years from the date liquid fund units were allotted, they will be taxed according to the prevailing LTCG laws. As of today, the capital gains will be taxed at 10% without indexation benefits and 20% with indexation.
While dividends are not currently taxable, fund houses do pay 25% as dividend distribution tax to the government. Consequentially, the returns are reduced, as this tax forms a portion of the expense ratio under the dividend option.
Today, as traditional methods of investment are losing their shine, many risk-averse investors are actively looking to invest in low-risk avenues that can offer them superior benefits and more liquidity. While liquid funds do offer a platform for quick wealth multiplication, investors do need to look at the prevailing tax laws to decide which option suits them the most.