For financial security, it is essential to have a contingency fund that can take care of your expenses for 3 to 6 months. Such a contingency fund can help tide over the short-term loss of income such as an extended leave due to illness, loss of a job, a decline in business, etc. It can also help cope with unforeseen expenses such as medical emergencies, among other things.
Many investors park their surplus money in a savings account to serve as contingency funds. A reason for this could be they do not want to lock their money in any investments. Or, they may not know other alternatives. But what if there is a better alternative where you can park your surplus money? Liquid funds can be an excellent financial instrument from an investment standpoint.
What is liquid fund?
Liquid mutual funds are types of debt funds that invest primarily in open-ended schemes which have a short-term investment horizon. They invest in money-market instruments such as commercial papers, treasury bills and certificate of deposit up to 91 days. The main objective of short term liquid funds is to provide income via creating ample liquidity and preserving your capital. Once you know how to invest in liquid funds, you can choose to invest for a few days or months depending on your financial requirement.
Liquid fund returns v/s savings account
In 2011, the Reserve Bank of India introduced changes and deregulated the interest rate on savings deposits. Before that, every bank would offer an interest rate of 4% per annum. Since the ruling, banks are now free to provide interest they deem fit. Typically, the returns now on savings account are still around 4%. If you fall in the highest tax bracket, the post-tax returns on savings account come to approximately 2.8%. Such a return may not counter inflation or help to accumulate wealth.
On the other hand, liquid funds offer returns in the range of 7% to 9% per annum. If you consider the post-tax return on the highest tax bracket, the percentage is about 5% to 6%. This is moderately higher than what a savings account offers.
Tax treatment
Interest on a savings account is taxable. However, there is also a deduction available under Section 80TTA up to Rs. 10,000 per year. If the interest income exceeds the said limit, the amount is taxable depending on your income tax bracket.
Here are some scenarios to consider:
- If you hold liquid funds for less than three years, tax on liquid funds is charged as per your income slab.
- If you hold liquid funds for more than three years, you become eligible for long-term capital gain tax at 20% with indexation benefit.
- If you opt for the dividend option, the dividend income is free, subject to a dividend distribution tax of 29.12%.
Conclusion
Thus, you could benefit more from investing in liquid funds if you have surplus cash. Not only would you earn better returns but also save on tax.