When it comes to saving money or setting up an emergency fund, most Indians typically stick to low-risk avenues like their savings account and fixed deposits. However, with banks lowering interest rates, investing in liquid funds assumes greater importance if you want to maximise your returns.
What are liquid funds
Liquid funds are debt funds that invest in short-term treasury bills, term deposits, commercial papers, and other short-term money market instruments with maturity of up to 91 days. You can invest in liquid funds through SIPs or as a lump sum.
Most liquid funds offer 2-3 options for investing – growth, monthly/weekly dividend option, which can be further classified as payout (money in your account) or re-investment option (additional units credited). You can choose an option depending on your cash flow and other requirements. While dividend is tax-free in your hands, the fund has to pay a Dividend Distribution Tax (DDT) before that.
Reason to invest in liquid funds
– Liquid funds usually do not have an entry or exit load, and no lock-in. The expense ratio is among the lowest, compared to equity or other debt funds
– The best performing liquid funds have given returns in the 7-8% range for a 1-3 year duration, which, is superior to returns from savings or fixed deposits after factoring tax and inflation
– They are also less risky and the maturity of their investments within 91 days makes them less susceptible to interest rate fluctuations
– As the name suggests, these funds are highly liquid – you can get your money in 1 business day. In fact, some mutual fund schemes now also allow you to withdraw your money in a matter of minutes, up to a specified limit. Confirm the redemption period, eligible amount and cut-off time with the fund house before you invest.
– They help prevent impulsive purchases – which you’re likely to do if the money is lying idle in your bank account 😉
Taxation of liquid funds
With bank deposits, you are required to pay tax on the earned interest when filing your income tax returns each year, whereas tax is levied on mutual fund gains only on actual redemption, depending on whether gains are short-term or long-term.
In the case of debt mutual funds (and liquid funds), short-term capital gains means redemption within 3 years, and long-term capital gains if redeemed after 3 years. Short-term capital gains are added to your income and taxed as per your tax slab. Long-term capital gains are taxed at 20% with indexation – which helps to adjust your purchase price, taking inflation into account.
Making your money work for you
If you have irregular income as a professional or freelancer, or suddenly get a windfall by way of an inheritance, sale of property or a bonus, or just have un-utilised money, you should make your money work for you instead of just letting it remain idle in your bank account.
One of the better ways to do this is via an STP – Systematic Transfer Plan.
First identify a good equity/balanced fund that you wish to invest in. Usually, you would transfer money from your bank account to this fund, either lump sum or as an SIP.
However, if you invest the bulk of the amount first in a liquid fund, you can set up an STP to transfer money periodically to the equity/balanced fund. This would increase the overall return on your investment due to higher yield from your liquid fund as compared to your bank account, besides the return on the equity/balanced fund.
What to keep in mind
The tenure of the STP can be decided based on your financial goals or comfort level or the amount in the liquid fund, so from 6 months/1 year to even 3 years. Keep an eye on the markets before over-committing your funds though.
Do remember that both the liquid fund and equity/balanced fund have to belong to the same fund house if you wish to use a Systematic Transfer Plan.
The most important thing of course, is to check the fund fact sheet, performance, risk profile and above all, the expense ratio – which will give your investment that added boost with higher returns.