Liquidity is back in the financial eco-system with 95% of the demonetized currency deposited into banks. This has induced the banks to lower interest rates in deposits and lending. Deposits are an expense for the banks, as they have to pay interest on them.
Liquidity is back in the financial eco-system with 95% of the demonetized currency deposited into banks. This has induced the banks to lower interest rates in deposits and lending. Deposits are an expense for the banks, as they have to pay interest on them. So with the increased liquidity, the interest rates are reduced on bank deposits, in a move that will discourage deposits.
While it is good news for vehicles, homes, and electronics buyers, it is time for investors to explore options other than fixed deposits. Investors like bank deposits as they are low-risk and offer assured returns. But at a time like this, they must look at alternatives with comparable risk. In this article, we will look at one such low-risk alternative — liquid funds.
Overview of liquid funds
Liquid funds, also known as money market funds, invest in short-term treasury bills, term deposits, commercial papers, certificate of deposits, and a few other short-term money market instruments with returns slightly higher than that of bank deposits. They fall in the debt funds category, and invest in assets with maturity of up to 91days.
Liquid funds are a hit with investors, who want to park their money in low-risk, liquid investment instruments which ensure better returns and higher tax efficiency than bank deposits. It takes 24 hours to redeem the fund and get the money deposited in the bank account.
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Features of liquid funds
You can select from a range of liquid funds offered by fund houses. These funds do not have an entry or exit load. The management fee (also known as the expense ratio) is 0.5-1%, which is much lower than that of equity or debt funds.
You can invest in liquid funds through lump sums or SIPs, just as you do for any other mutual fund. You can invest lump sums as small as Rs. 5000.
Taxation of liquid funds
Bank deposits currently offer 4-7% interest and after tax deductions, the effective returns are much lower compared to liquid funds. If you’re in the 30% tax bracket investing in a fixed deposit earning 6.5% annually, your post-tax interest earnings from the deposit would be 4.55%. It’s here that deposits compare unfavourably with liquid funds.
Liquid funds have been earning in the range of 8-9% per year for the last few years. Even though returns in the last year have come down to around 7.5%, they are continuing to earn marginally higher than the deposits offered by most banks.
Unlike bank deposits upon which tax has to be paid annually on all interest earnings, mutual funds get taxed only when you liquidate them. Liquid funds follow the taxation structure of debt mutual funds. There are two types of taxes, namely short-term capital gain (STCG) tax and long-term capital gain (LTCG) tax associated with it.
‘Short term’ in case of debt funds applies to any redemption carried out in less than three years. In case of equities, ‘short term’ stands for a period less than one year. Short-term capital gains are added to your income and taxed as per the tax slab.
‘Long term’ stands for a period more than three years in case of debt funds. If an investor redeems after three years of investment, he is liable to pay the LTCG tax of 20% on capital gains after indexation. The indexation method helps you determine the inflation-adjusted purchase price for your investment, thus significantly reducing your tax incidence.
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Liquid funds is a popular short-term investment instrument among people who are looking to invest for a few months. For example, if you have Rs. 5 lakh and you want to buy something after three months, you might want to put the money in a liquid fund instead bank deposits as the returns are relatively higher.
In the last one year, the best funds have fetched return of up to 7.5 to 8%. It also keeps the money safe from impulsive spending unlike savings in bank accounts.
(The writer is CEO of BankBazaar)