Personal Finance

Liquid funds haven’t lost all their lustre

Radhika Merwin | Updated on: Sep 21, 2014
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If your investment horizon is less than one year, they trump savings account returns and are more liquid than FDs

The Budget took away most of the tax advantages that debt mutual funds enjoyed over bank products. But if you’re looking to park money for less than a year, liquid funds still make a lot of sense. Here’s why.

Where the axe fell The tax structure for debt funds has been changed in two ways. Earlier, all capital gains made on debt funds held for more than one year were treated as ‘long-term’ and taxed at a flat 10 per cent. But now, the tenure for claiming long-term capital gains tax on debt funds has been increased to three years. The tax rate on such long-term gains has also been hiked to 20 per cent (with indexation benefits) instead of a flat 10 per cent. So for liquid fund investors, any money you park in liquid funds for one to three years will now be subject to taxes at a higher rate.

Still a good option But this tweak does not change the game for liquid fund investors in a big way as liquid funds are in any case not well-suited for investments with a horizon of more than one-year. Liquid funds invest primarily in money market instruments like certificates of deposit, treasury bills, commercial papers and term deposits.

These funds have no lock-in period and do not carry entry or exit loads. These funds also carry a lower rate risk than other debt funds as they invest in fixed income securities with maturity up to 91 days. Given this profile, liquid funds tend to be the best fit for investors with very short investment horizons of six months to less than a year.

For investors looking at liquid funds for a period less than one year, there has actually been no change in taxation. Their returns on liquid funds were earlier taxed at their income tax slab rates and they will continue to be taxed as such.

However, there was one other tweak in the tax structure of debt funds in the Budget through an increase in dividend distribution tax. Earlier, the tax was calculated on the net amount distributed as dividend. Now, it will be calculated on the gross amount distributed. So while dividends from all debt funds were taxed at a rate of a little over 22 per cent until the Budget, this rate has increased to slightly over 28 per cent now.

So if you are not particular about periodic cash flows, but want to have a lower tax outgo, you can do some tax planning.

Investors in the 10-20 per cent bracket can opt for the growth option rather than the dividend option since the effective tax rate will be lower under the growth option. For investors in the 30 per cent tax bracket, they could choose either the dividend or growth option, depending on their requirement.

Scores on returns Does parking money in plain Jane savings accounts to avoid tax hassles make sense? Yes, savings accounts score on two aspects. For one, interest up to ₹10,000 is exempt under Section 80TTA of the Income Tax Act and can be deducted from your income like insurance premium payments, PPF investments, etc. Secondly, bank accounts also score on safety, with investments of up to ₹1 lakh covered by deposit insurance.

But it is on returns that liquid funds score, through active management of their portfolios. Liquid funds have delivered 7-8 per cent returns annually over the last five years while savings banks have offered 4 to 6 per cent. Of course, this comes at the price of slightly higher risk.

Can you push up the returns from your bank by investing in an FD for less than one year? Bank FDs with a tenure of up to one year today offer 9 per cent interest.

But the interest income is taxable at your slab rates, so your effective returns will be lower. Besides, should you need the money before maturity, you will be charged a penalty for premature withdrawal which may further bring down your returns.

Therefore, if you don’t mind taking a bit more risk and liquidity is your priority, liquid funds are ideal.

You will be able to exit investments whenever you need cash. This is also the reason why HNIs and businesses prefer liquid funds over comparable bank options.

Published on November 19, 2014

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