What are Liquid Funds?
Liquid funds are a type of debt mutual funds which primarily invest in money market securities as short as one day. As the name implies, these funds have high liquidity and the returns are less fluctuating since these funds invest in securities which are maturing in very short-term.
In addition, these funds offer higher returns than saving deposits. However, these funds offer lower returns than other debt funds since these funds invest in fixed income securities with shorter tenors.
There is no entry load and exit load on liquid funds. Liquid funds provide better returns in high inflation scenario when RBI normally keeps interest rates high and tighten liquidity to contain inflation.
Since investors invest in liquid funds for short-term, say a day to few months, a short-term capital gains tax is levied on these funds based on investors’ applicable income tax slab’s tax rate. However, the interest earned on saving account is also taxable based on applicable income tax slab.
Despite the above benefits there are number of other advantages of liquid funds, which are stated below.
Benefits of Liquid Funds are-
1. Ideal product for cash management:
Liquid funds are ideal product for short term investing instead of saving in a saving account. These funds invest in securities with less than 30 days maturity. There is no lock in period in these funds. One can invest for even one day in them.
2. Lower Risk:
Since liquid funds invest in short-term securities which are maturing with a month. Therefore, these funds are less volatile than other debt funds because in near-term the default risk and interest rate risk is low.
3. Easy to redeem:
Liquid funds are easy to redeem. One can redeem money with one day prior notice, if you redeem your liquid fund investment before 2 PM, you will get money by 10 AM next morning in your account. Other major benefit is, you can do partial withdrawals in debt funds, which is not possible in case of bank FD.
4. Returns can be higher than bank FD:
The return on liquid funds can be more than fixed deposit. In times of higher interest rates, liquid funds can deliver better returns compared to bank FD.
5. Taxation – Indexation (Cost Inflation Index) benefit after 3 years
After three year of investments, a long-term capital gains tax is levied on debt funds at 20% with indexation. Indexation is adjusting investments for inflation for holding period. The longer the holding period of Invested funds, higher the benefit of indexation.
Let’s assume, 3 years ago, say on 15th January 2013, a person invested Rs. 1,00,000 in liquid funds which gave him a return of 8.5% and when he redeemed on 15th January 2016 (after three years) he got Rs. 1,27,729. His total gain was Rs. 27,729 but after adjusting for indexation (adjusting for the inflation during the investment period; 2012-13 CII was 852 and 2015-16 CII was 1081), his taxable gain was only Rs. 851. Thus, the post-tax net return was 8.44%. The indexation benefit is not available on saving account, FDs and RDs; it is only available on debt mutual funds if the holding period is more than 3 years.
In summation, these funds are a good substitute to regular saving account since the liquidity is high, give more returns than regular saving account and have taxation benefits. Therefore, investors can invest their emergency funds in liquid funds.