Make your contingency fund earn more for you

Satya Sontanam BL Research Bureau | Updated on December 20, 2019 Published on December 19, 2019

There are instruments that offer liquidity as well as higher returns on savings

Maintaining a high balance in your savings bank account to meet your contingencies? It may not be a great idea to let funds idle in your savings account, as most banks offer meagre rates on savings deposits.

After SBI recently lowered the interest rate on low-value savings deposits to 3.25 per cent, many other PSU banks followed suit and now offer a measly 3.25 per cent on such deposits. Private sector banks such as HDFC Bank, ICICI Bank and Axis Bank offer a slightly higher rate of 3.5 per cent on savings deposits up to ₹50 lakh, which is still rather modest.

Thus, parking huge sums in savings accounts may not be the most efficient way to manage your surplus money. It is true that liquidity, convenience and ease of access are of paramount importance for contingency funds. While savings deposits seem the obvious choice, there are other instruments that meet these demands and also offer higher returns on your savings.

While a few banks such as IDFC First Bank and Kotak Bank offer 6-7 per cent interest on savings deposits with higher balances, opening another running account (if you are banking with another bank) and maintaining the minimum balance may be tedious and come at a cost.

Instead, you can boost your returns by either investing the surplus in liquid funds or opting for an automatic ‘sweep’ facility that moves excess money from your savings account into a fixed deposit. Here’s a look at each of these options.

Automatic sweep

If you are wary of taking market risks and prefer bank deposits, you can consider an automatic ‘sweep’ facility. This can help move surplus money from your savings account into a fixed deposit, earning you higher returns without compromising on liquidity. This is because, in the case of a shortfall, money can be moved back to your savings account.

But not all types of savings accounts provide automatic sweep and reverse sweep facilities. Also, while you can set the sweep limits for your savings accounts, banks do specify minimum/maximum thresholds. Take ICICI Bank, for instance. Any idle amount in its Gold Plus Savings Account above the threshold of ₹75,000 moves automatically into FDs in multiples of ₹25,000. The minimum amount for a fixed deposit is ₹25,000.

On the other hand, HDFC Bank does not allow sweep-ins/sweep-outs from FDs of amounts greater than or equal to ₹5 crore crore and less than ₹25 crore.

You also need to know the tenure for which the FD is created. Axis Bank’s Encash allows you to choose between six months and five years, while HDFC Bank creates fixed deposits for one-year and one-day periods.

Since the rates vary across tenures, returns from sweep accounts depend on the tenure chosen and the applicable interest rates. But should you need the money before maturity, you will be charged a penalty for premature withdrawal.

Tax treatment: While interest income from the savings bank account is tax-free up to ₹10,000 under section 80 TTA of the Income-Tax Act, tax treatment for the interest income from sweep-in accounts is the same as that of fixed deposits. The whole income is taxable at the customer’s respective income-tax slab rate.

The post-tax returns from sweep-in accounts, after penalty (if any), may bring down your returns.

Bottomline: If you do not want to take any risk with your contingency funds but want to earn slightly higher returns than from savings accounts, you can consider sweep-in options. But you need to understand the fineprint of each bank’s sweep facility before choosing this option.

Liquid funds

If you are willing to take a little market risk, then liquid funds can be another option to earn higher returns. Liquid funds are a type of debt mutual funds that invest primarily in money market instruments such as certificates of deposit, treasury bills and commercial paper with maturity up to 91 days.

Liquid funds are open-ended schemes, have no lock-in period and do not carry entry or exit loads (currently, exit load is applicable only if investors exit the fund within seven days).

In 2017, SEBI approved the instant access facility in liquid funds. Thus, on redemption, the proceeds are credited in the investor’s bank account on the same day of online request. Note that there is a limit for the instant access facility — ₹50,000 or 90 per cent of the latest value of investment in the scheme, whichever is lower. This limit is applicable per day per scheme per investor.

Mutual fund houses such as Nippon India Mutual Fund also offer ‘Any Time Money Card’, an ATM-cum-debit card that offers easy access to investments in liquid schemes at Visa-enabled ATMs.

However, as mutual funds are market-linked, liquid funds are slightly riskier than bank FDs. Also, unlike investments in FDs, there is no assured interest rate. The returns depend on the price movement of the underlying bonds in the fund’s portfolio.

Nevertheless, liquid funds are considered relatively less risky than other debt funds due to the short-term nature of the investments, which mitigates interest rate risk. The credit risk is also lower in these funds.

Also, to ensure instant redemption, SEBI has mandated fund houses offering liquid funds to set aside in cash at least three times the last one month’s or three months’ daily average of redemptions — whichever is higher — on a rolling day basis.

Liquid funds score high on returns compared to savings deposits. The top liquid funds have delivered 6.5-8 per cent returns annually over the past 10 years.

Thus, if you are willing to take a slightly higher risk, liquid funds can offer better returns. But there is the tax aspect to consider.

Tax treatment: The returns from liquid funds are treated as capital gains. If held for less than three years, the gains — the difference between the redemption value and the investment amount — is treated as short-term capital gains and taxed at the applicable income-tax slab rate. If held for more than three years, the difference is taxed at 20 per cent with indexation benefit.

Bottomline: If your contingency fund is substantial and you are willing to take some risk, you can consider liquid funds for a portion of your surplus. Go for the growth option instead of dividend option in liquid funds as the tax on dividend — dividend distribution tax — can go up to 29.12 per cent.

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Published on December 19, 2019
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