Liquid Funds: Meaning, Benefits, Taxation

What are Liquid Funds?

Liquid funds are a type of mutual fund that primarily invests in short-term money market instruments such as treasury bills, certificates of deposit, commercial paper, and short-term government securities. These funds are designed to offer investors a high degree of liquidity and relatively stable returns over a short investment horizon.

The returns earned by a liquid fund depend on the market price of the securities held by the fund. The prices of short-term securities do not fluctuate as much as long-term securities.

How do Liquid Funds Work?

• Where do Liquid Funds Invest?
  Liquid funds generally invest in short-term securities that have high liquidity and good credit quality.
  As per the latest SEBI norms, the liquid funds can invest only in listed commercial papers, and their overall exposure limit is 20%. These funds cannot invest in assets that hold any financial risk. Also, at least 20% of the assets in the portfolio of liquid funds should be highly liquid.
• What are the Sources of Earnings from Liquid Funds?
  The main source of earnings for liquid funds is the interest earned on debt-based assets. And a small portion of their earnings comes from capital gains. There exists a negative relationship between bond prices and interest rates. This relationship has a stronger impact on long-term funds as compared to short-term funds.
  Since liquid funds only invest in short-term securities, the market value of these funds does not change much as a response to changes in market price. At the same time, with an increase in interest rates, liquid funds perform better than other debt funds. While they earn a higher interest income, they have to bear limited capital losses.

What are the Benefits of Liquid Funds?

Liquid funds come with multiple advantages for investors. Given below is a list of the benefits of a liquid fund -

• Low-Risk: A liquid fund is a debt fund that has a low risk and ensures steady and consistent returns along with the safety of the principal amount.
• Low-Cost: Liquid funds are debt funds that are low-cost as they are not actively managed, unlike other debt funds. Most of the liquid funds have an expense ratio of less than 1%. This structure allows them to maximize their returns.
• Quick Redemption: Fund redemption requests are processed within one working day. Some funds also allow instant redemption. Since liquid funds invest in highly liquid instruments, they can be redeemed instantly without the probability of default.
• Flexible Holding Period: Investors in a liquid fund have the freedom to retain their investment for as long as needed. While a modest exit load is applied for redemptions within seven days, liquid funds offer versatility in holding periods. This flexibility makes it easier to enter or exit the market.

Who Should Invest in Liquid Funds?

Liquid funds are suitable for a wide range of investors, including:

• Individual Investors: Individuals who have surplus funds and want to earn higher returns than traditional savings accounts while maintaining easy access to their money may consider investing in liquid funds.
• Corporate Investors: Companies and corporate treasuries often use liquid funds to manage their short-term cash reserves efficiently. These funds provide a balance between safety, liquidity, and returns, making them suitable for corporate cash management.
• Emergency Fund Allocation: Liquid funds can be a good option for building emergency funds. Since they offer high liquidity, investors can easily access their funds in case of unexpected expenses or financial emergencies.
• Short-Term Financial Goals: Investors with short-term financial goals, such as saving for a vacation, purchasing a vehicle, or making a down payment on a house, may find liquid funds suitable. These funds offer stable returns over the short term and can help investors achieve their goals without exposing their investments to significant risk.
• Tax-Sensitive Investors: Liquid funds can be tax-efficient for investors in higher tax brackets. Gains from liquid funds held for more than three years are taxed as long-term capital gains, attracting lower tax rates compared to interest income from savings accounts or fixed deposits.
• Risk-Averse Investors: Investors who prioritize capital preservation and are averse to taking significant investment risks may find liquid funds attractive. These funds invest in high-quality, short-term debt instruments, which helps minimize the risk of capital loss while providing a modest level of returns.
• Investors with Short Investment Horizons: Liquid funds are ideal for investors with short investment horizons who need to park their funds temporarily or have immediate cash needs. These funds offer high liquidity, allowing investors to redeem their investments quickly without incurring significant penalties or fees.

Things to Consider Before Investing in Liquid Funds

Before you go ahead and start investing in liquid investment funds, here are a few things that you need to consider -

• Risk: Liquid funds carry a risk associated with fluctuations in the net asset value (NAV). Although the NAV in liquid funds remains relatively stable due to short maturity periods, a sudden decrease in credit rating can impact the fund’s value.
• Returns: Historically, liquid funds have yielded profits ranging from 7% to 9%, surpassing the meager 4% returns offered by savings bank accounts. While returns are not guaranteed, liquid funds often earn profits at the time of redemption.
• Cost: Liquid funds incur a small fee known as the expense ratio, capped by SEBI at 1.05%. With a hold-till-maturity strategy, these funds maintain a low expense ratio to offer comparatively higher short-term returns.
• Investment Horizon: Ideal for short periods (up to three months), liquid funds maximize the potential of underlying securities. If you can invest for longer a period, consider ultra-short-term funds for relatively higher returns within a year.
• Financial Goals: Liquid funds are valuable for creating emergency funds, providing both higher returns and quick access to funds during emergencies.
• Tax on Gains: Gains from liquid funds are subject to taxation. Short-term capital gains (STCG) within three years are added to your income and taxed at the applicable slab rate. Long-term capital gains (LTCG) after three years incur a flat 20% tax rate after indexation. Dividends from mutual funds are added to overall income and taxed at the applicable slab rate.

What is Liquid Mutual Funds Taxation?

Investors can earn both capital gains and dividends from liquid mutual funds. While the interest earned from such investments is not chargeable to tax, any capital gains arising from these investments are subject to tax as follows -

• Short-term Capital Gains - If an investor sells/redeems the liquid fund within 3 years of the date of purchase at a price higher than the purchase price, then such gains are known as capital gains. These are taxed at income tax slab rates applicable to the investor.
• Long-term Capital Gains - If the investor sells/redeems the liquid fund after holding it for more than 3 years, such a gain is treated as capital gain, and the investor gets the indexation benefit (purchase price adjusted to account for inflation before calculating capital gain). Long-term capital gains are taxed at the rate of 20%.

Navigating the complexities of liquid fund taxation can be challenging. Therefore, seeking guidance from tax experts is advisable to ensure optimal financial decision-making. By comprehending the benefits and intricacies of liquid funds, investors can make informed choices and harness the full potential of these funds while mitigating risks. Remember, expert advice is the key to navigating the tax landscape seamlessly. Get Expert Consultation Today