When you create an emergency fund, you have a choice between a savings account and a liquid mutual fund. Which of the two is better for you and why?
A very important part of your financial plan is an emergency plan or a contingency plan. While there are no hard and fast rules, it is estimated that your emergency fund should be equivalent to 6 months of your expenses. This should be the funds that you hold in liquid format; either in a savings bank account or in a liquid mutual fund. The idea of a liquid form is to ensure that in the event of an emergency you are able to convert the same into cash at very short notice. Why do we need an emergency fund? There could be various reasons for the same.
Firstly, there could be contingencies like accidents, emergencies, sudden travel which may require putting up quick cash urgently. You cannot be going around asking for cash or trying to monetize your investments at a loss (that is what happens in a distress sale). Here, access to liquidity is very important. Secondly, if you have elderly dependents you need to keep liquidity handy with you. You may require sudden medical emergencies or sudden hospitalization and even if you have medical insurance it still calls for cash requirements. Thirdly, your company may run into a liquidity crunch making it difficult to pay your salaries on time. Alternatively, you may suddenly lose your job and you may find it hard to immediately get another job in a tight market. Here your liquidity plays an important role. Lastly, many professionals prefer to become entrepreneurs after a stage. A business is a business, after all, and there is no assurance of cash flows. Here again, an emergency fund will come in handy.
5 basic rules for your emergency fund
Here are 5 basic rules you must follow when you create an emergency fund
1. Build your emergency fund in two phases. Set up an emergency fund to the extent of 3-months’ expenses first and then review how it is working. Then you can look to gradually build the emergency fund to 6-months expenses.
2. Don’t try to use your lump-sum receipts entirely to create an emergency fund. That is inefficient use of resources. Build your fund gradually and in sync with your growing expenses levels. That way you do not feel the pressure.
3. Don’t over allocate to an emergency fund. Remember, your emergency fund will be invested in liquid assets with low returns and low risk. If you decide to hold 12-months expenses as emergency fund that is sub-optimal allocation of your money. Don’t overdo it.
4. Make it a point to replenish the fund when you use it up. You cannot treat it like an ATM card that you just draw upon. There are emergencies when you fall back upon your emergency fund. Make it a point to replenish and bring it back to the 6-month level.
5. Be careful about where you invest your emergency funds. It should be invested in very liquid assets. That means; you can put the money in a savings bank account or in a liquid mutual fund. Some investors hold emergency funds in short term bond funds and debt funds. These funds are subject to interest rate risk and also carry exit loads. Be careful in your choice.
Emergency Fund – Savings Account Vs Liquid Fund
When you create an emergency fund, you have a choice between a savings account and a liquid mutual fund. Here is what you need to know:
# Savings bank accounts are the safest mode of keeping emergency funds, but the rate of interest is just 4%. That is also paid out only on the minimum balance between the 10th and the last day of the month. Liquid Funds, on an average pay around 6.0-6.5% return.
# When you select a liquid fund, focus on the portfolio maturity of the liquid fund. Ideally, your liquid fund should be holding assets with less than 90 days maturity. These are actually short term instruments and not impacted by interest rate movements.
# Do not opt for a dividend option in liquid funds. For tax purposes, liquid funds are treated as non-equity funds and hence they are subject to dividend distribution tax (DDT) at 29.12% (25% tax + 12% surcharge + 4% cess).
# A better idea is to opt for the growth option of a liquid fund. When you hold liquid funds for a period of more than 3 years it is treated as long term capital gains (LTCG) and taxed at 20% after the benefit of indexation.
How liquid funds score over savings account in returns and tax efficiency
Let us assume that Manish with monthly expenses of Rs 75,000 has set aside Rs 4.50 lakh in an emergency fund (6 months equivalent). Consider a period of 3 years and 5 days.
|Particulars||Interest on Savings (4%)||Post Tax Income*||Particulars||CAGR on liquid funds (6.5%)|
|First Year||Rs.18,000||Rs.12,600||First Year||Rs.4,79,250|
|Second Year||Rs.18,000||Rs.12,600||Second Year||Rs.5,10,401|
|Third Year||Rs.18,000||Rs.12,600||Third Year||Rs.5,43,577|
|Total Post Tax Interest earned||Rs.37,800||Indexed Cost of Acquisition||Rs.5,10,000|
|Indexed Capital Gains 3 yrs||Rs.33,577|
|Tax on Capital Gains 20%||Rs.6,715|
|Post Tax Income Earned||Rs.86,862|
*Assuming tax bracket of 30%
As can be seen in the above illustration, the investor is substantially better off at the end of 3 years had he parked his emergency fund in a liquid fund instead of a savings bank account. Remember, some of the liquid funds offer the same day redemption and also offer ATM facility in tie-up with banks. So, go ahead and make even your emergency fund work harder for you!
(By Vivek Shukla, Head of Products, Angel Broking)