It’s important for everyone to have cash reserves for the unexpected moments. Emergencies can arrive at any moment and we should take the financial steps that would make it easy for us to tackle those emergencies.
An emergency fund, by its nature, should be a liquid fund. Typically we lock up such money in savings accounts or deposits. They are reliable, safe and liquid. Savings accounts will fetch you an annualised return of 4 per cent-6 per cent depending on the bank that you are associated with. However, with the growing popularity of mutual funds, liquid funds are emerging as a good alternative for parking surplus money.
Before discussing why liquid funds can be an alternative or even a supplement to savings account, let’s briefly understand what these funds are.
What Are Liquid Funds?
Liquid funds are open-ended debt mutual fund schemes which invest the corpus into short term money market instruments like short term corporate papers, treasury bills and certificates of deposit with short maturity period. The objective of liquid fund is to generate return with high level liquidity and nominal risk. Liquid funds have no entry and exit loads and can be liquidated within a day. They are also available with different investment options like growth, and daily, weekly, or monthly dividend.
Why Liquid Funds?
With the below points, let’s understand how liquid funds can perform better than savings accounts.
Return: Liquid funds can earn you better returns in a scenario when interest rates are trending downwards, as they have been since the beginning of 2015.
As per the CRISIL AMFI study in June 2016, the average returns of liquid funds as on June 30, 2016 are as below:
Hence, we can say that these returns are considerably higher than the savings bank interest rates which are typically in the range of 4%-6%.
Taxation: In the case of savings accounts, the Income Tax Department gives a deduction up to Rs.10,000 for interest earned on all your savings accounts under Section 80TTA. Interest earned over and above the limit is taxed as per your tax slab. Interest on savings account is calculated on a daily balance basis.
In case of liquid funds, investments held for less than three years are treated as short term investments, and capital gains will be taxed as per your individual tax slab. Any investment held for more than three years are considered as long term investments and capital gains will be taxed at 20% with indexation benefit.
The tax treatment also differs with the growth and dividend plans that you opt for. Dividend distribution tax for liquid funds with dividend option is 28.84%. Investors in the highest tax bracket will earn more under the dividend option.
Let’s understand the tax implications on return with an illustration of two different scenarios for parking funds both in savings account (after consuming deduction benefit) and liquid fund.
Let’s assume Mr. John Smith invests Rs. 4 lakh in liquid funds for a year and same amount in savings account for a year as well.
This shows liquid funds provide you a tax efficient return when compared with savings account.
On a closing note, liquid funds extend the advantage of high returns along with basic principal of accessibility and safety while maintaining a healthy contingency fund. Hence, it would be wise to park your surplus funds into liquid mutual funds.
The author is CEO, BankBazaar.com