The debt fund section has evolved over the years and is classified into several sub-categories based on their development period or the type of underlying security. Within this world, liquid funds have for long been the short-term parking ground for corporates and HNIs for the liquidity they appear.
What are liquid funds?
Debt funds that only invest in securities with a residual maturity of not more than 91 days are quick. Currently, the average portfolio maturity of funds in this section ranges between three and 52 days. Investments are mostly in money market tools, short-term corporate deposits, and treasury bills.
Why fund in liquid funds?
Liquid funds help you earn higher profits than a regular savings bank account or short-term fixed deposit, with negligible opportunity and without compromising on liquidity. Salvation from liquid funds is usually credited to your bank account in one working day. Some stores also offer instant redemption up to a preponderance of Rs 50,000 or 90 percent of your investment value, whichever is lower.
While liquidity is one circumstance that makes these funds attractive, their relative safety makes them the favored parking option for HNIs and corporates or even retail investors to park their contingency corpus or a huge sum of money. As opposed to other debt funds, these funds are relatively less sensitive to interest rate variations because of their mandate to invest in securities with a maturity period of up to 91 days. Though credit risk commands, there have been only rare instances of defaults in this section as these funds usually invest in instruments of high credit quality.
How are they taxed?
The gains from liquid funds are treated as capital gains and taxed only when they are realized. If you sell your stake in liquid funds within three years, the gains are added to your income and taxed at the relevant slab rate. If you sell them after 3 years, the profits are taxed at 20 percent after providing for the indexation benefit.
For investments made up to the last fiscal year, dividends, if opted for, were tax-free in the controls of the investor. However, they were subjected to a Dividend Distribution Tax (DDT) of 29.12 percent which was diffusely charged to the investor - it used to be subtracted from the declared dividend before being passed on to the investor. However, ever since April 1, 2020, there is no extended DDT, but dividends are added to an investor's income and taxed at the appropriate slab rate.
To conclude, liquid funds are a good option for savings accounts or bank deposits as they offer better returns while being liquid.