Liquid funds are a category of mutual funds in India that primarily invest in short-term, highly liquid debt instruments known for their safety, liquidity, and stability. Liquid funds are considered one of the safest investment options in the mutual fund universe and mainly allocate their funds in the following different instruments:
- Certificate of Deposits (CDs): These are short-term debt instruments issued by banks and financial institutions. CDs have fixed maturities and offer a predetermined interest rate.
- Commercial Paper (CP): Commercial paper is a short-term unsecured debt instrument issued by highly rated corporations. It provides companies with a way to raise short-term funds.
- Treasury Bills (T-Bills): These are government securities with very short maturities, typically ranging from a few days to one year. T-Bills are considered among the safest investments as they are backed by the government.
- Short-term Government Securities: Liquid funds can also invest in short-term government bonds and securities issued by the central and state governments.
Liquid funds also distribute their income among other money market instruments like bank fixed deposits, call and notice money, etc. However, their main theme is that they protect the investments at all costs and can be easily withdrawn, hence the term ‘liquid’.
Liquid funds are designed to offer investors a way to park their surplus funds for the short term while earning potentially higher returns than traditional savings accounts or fixed deposits. They provide easy access to your money, typically allowing for quick redemptions, making them suitable for emergency funds, short-term financial goals, or for investors who need a place to temporarily store their cash.
Are Liquid Funds Tax-Free?
This is a common misconception that has many potential investors of liquid funds. Overall, the answer is no. Currently, the returns from liquid funds in India are taxed like the earnings on any other debt mutual funds in India.
The capital gains on liquid funds are taxed depending on the holding period, as follows:
- Short-term capital gains: If you sell your liquid fund units within 3 years of buying them, the capital gains are taxed as short-term capital gains. Short-term capital gains are taxed at your income tax slab rate.
- Long-term capital gains: If you sell your liquid fund units after 3 years of buying them, the capital gains are taxed as long-term capital gains. Long-term capital gains up to ₹1 lakh are exempt from tax. Beyond ₹1 lakh, long-term capital gains are taxed at 20% after indexation. Indexation is the process of adjusting the purchase price of your liquid fund units to account for inflation. This reduces your taxable capital gains and saves you tax.
Dividend Distribution Tax (DDT)
Here’s where many people get confused. The dividends from liquid funds ar enot subject to tax for the investor. To start at the beginning, liquid funds often pay dividends to their investors.
While dividends from liquid funds are taxed at a rate of 28.84%, irrespective of the holding period, this tax is deducted by the mutual fund company at the source and credited to the government.
Therefore, as an investor, the dividends received from liquid funds are tax-free. However, other returns such as capital gains are taxable at varied rates.
Liquid Funds Taxation Calculation
Example 1: Tax on Short-Term Gains
Suppose you invested ₹10,000 in a liquid fund and sold it after 2 years for ₹12,000. Your capital gain is ₹2,000. Since you have sold the liquid fund units within 3 years of buying them, you have made a short-term capital gain.
If your income tax slab rate is 20%, then you will have to pay a tax of ₹400 on your capital gain.
Short-term capital gain = ₹2,000
Income tax slab rate = 20%
Tax = 2,000 * 20/100 = ₹400
Example 2: Tax on Long-Term Gains
Now, suppose you invested ₹10,000 in a liquid fund and sold it after 4 years for ₹15,000. Your capital gain is ₹5,000. Since you have sold the liquid fund units after 3 years of buying them, you have made a long-term capital gain.
The first ₹1 lakh of your long-term capital gain is exempt from tax. Therefore, you will have to pay tax on only ₹4,000 (5,000 – 1,000).
Your long-term capital gain will be taxed at 20% after indexation. To calculate the indexed capital gain, you will need to use the Cost Inflation Index (CII) published by the Central Board of
Direct Taxes (CBDT).
Indexed capital gain = Actual capital gain * (CII for the year of sale / CII for the year of purchase)
Suppose the CII for the year of sale is 300 and the CII for the year of purchase is 200. Then, your indexed capital gain will be:
Indexed capital gain = 5,000 * (300 / 200) = ₹7,500
The tax on your long-term capital gain will be:
Tax = Indexed capital gain * 20/100 = 7,500 * 20/100 = ₹1,500
Therefore, the total tax you will have to pay on your capital gain is ₹1,500.
Liquid funds are a good investment option for investors who are looking for a place to park their money for a short period of time. They are also a good option for investors who are looking for a low-risk investment option. However, it is important to be aware of the tax implications of investing in liquid funds before you make an investment decision.