Banks are flush with deposits, thanks to the Centre’s demonetisation scheme. Rates on your humble fixed deposits that have been falling significantly over the last couple of months, can move lower. You may not want your funds to idle away in the savings account. Locking funds into fixed deposits at lower rates may also not appeal to you.

Investing the surplus in liquid funds that have a track record of offering better returns than your bank deposits may sound like a good idea. But choosing between growth and dividend option and timing your investment will be critical.

Just like any other mutual fund, liquid funds also come with two options — growth and dividend. Under the growth plan, the units of liquid funds redeemed before 36 months from the date of allotment attract short-term capital gains tax and the returns are taxed at the income tax slab rates.

The units that are redeemed after 36 months attract long-term capital gains tax at the rate of 20 per cent with indexation benefits.

On the other hand, under a dividend plan, while dividends declared by funds are not taxable in the hands of the individual, all non-equity funds attract a dividend distribution tax (DDT) of 28.84 per cent which is deducted and then given to the investor.

Thus, taxation plays an important role in deciding the investment option.

When not to invest

If you wish to park your money in liquid funds for a very short period, say less than 10 days, then you need to be careful while investing in the dividend plan of the liquid funds — under the monthly, quarterly, half-yearly or yearly options.

Entering into such dividend options a few days prior to record date can lead to loss in capital while redeeming the units. How?

Under a dividend option, the NAV of the fund falls to the extent of the total dividend (gross) after its payment. But the dividend (net) you receive is after the deduction of the DDT.

Hence, you would end up getting only 71.16 paise on a dividend of ₹1 declared by the fund. The NAV of the fund, though, gets adjusted to the extent of gross dividend (₹1).

Since you are a very short-term investor, you will have to bear this loss in capital. Table 1 depicts this loss under two different liquid funds with different payout options – ‘HDFC Liquid Fund Monthly Dividend’ and ‘Reliance Liquid - Cash Plan Quarterly dividend’. The capital of ₹1 crore is invested one or two days prior to the record date and redeemed on the 5th day.

When to invest or exit

To make good the loss, you must stay invested for at least 10 days under a monthly dividend option or at least 25 days under a quarterly dividend option.

If you have invested in half yearly or yearly option, you will have to stay invested for a much longer time to recover your capital loss.

Another way to avoid such losses would be to invest in the daily dividend pay-out option, as NAV would more or less remain unchanged every day.

At the same time, it is important to note that investment done in the same monthly or quarterly dividend option, post the record date, will not lead to capital loss. Hence you can redeem at any point of time.

Different tax brackets

Liquid funds on an average have delivered 7-8 per cent returns annually over the last five years. But the returns generated by these funds have fallen in the last two years.

As of November 2016, the liquid fund category (excluding direct plans) posted an average return of 7.45 per cent over the last one year.

For investors looking at liquid funds for a period of less than three years, their returns will be taxed at the income tax slab rates. Savings accounts score better on the tax front; interest up to ₹10,000 is exempt under Section 80TTA of the Income Tax Act.

If we assume 7 per cent return on liquid funds, post-tax returns work out to 6.3 per cent, 5.6 per cent and 4.8 per cent respectively for individuals in the 10, 20 and 30 per cent tax bracket. This is higher than the 4 per cent that most banks offer.

A few banks — YES Bank, Kotak Bank, IndusInd Bank, Lakshmi Vilas Bank and RBL Bank — offer a higher 6 per cent interest on high-value deposits.

Deposits offered by these banks may be a better option, particularly if you fall into a higher tax bracket of 20 or 30 per cent. But remember that the tax exemption on interest is only up to ₹10,000. If you hold over ₹2,50,000 in savings accounts, liquid funds would still offer better returns.

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, dividend option (DDT at 28.8 per cent), may be a better option, as any redemption before 36 months would attract a tax of 30.9 per cent.

In case the investor’s income exceeds ₹1 crore, remember that the short-term capital gains tax will be higher at 35.53 per cent due to surcharge of 15 per cent.

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