Should I Use Liquid Funds for Extra Money? Exploring the Benefits and Risks

When considering where to park your extra money, you might be torn between liquid funds and a savings account. Both options have their pros and cons, and the best choice depends on your specific financial goals and circumstances. This article will delve into the advantages of liquid funds, the process of withdrawing money, and the risks involved.

Understanding Liquid Funds

Liquid funds are a type of debt mutual fund that invests in short-term debt instruments. The net asset value (NAV) of liquid funds can fluctuate, but due to the short duration of their underlying assets, the risk is minimized. Liquid funds typically offer returns between 7-9%, making them more attractive than traditional savings accounts. They are ideal for those who need to keep money liquid while still earning a reasonable return.

Key Features of Liquid Funds:

Invest in short-term securities like certificates of deposit (CDs), treasury bills (T-Bills), commercial papers, and more. Offer returns as high as 7-9%. Allows you to invest for as little as one day. Flexible liquidity; you can withdraw your money at any time without penalty.

Why Use Liquid Funds for Extra Money?

Liquid funds are particularly beneficial for:

Corporates and high net worth individuals (HNIs) who want to earn returns on their money without taking on high risk. Investors who need temporary liquidity while planning for other investments. Individuals looking to diversify their investment portfolio without investing in high-risk equity mutual funds. Brokers who earn commissions on fund circulation. Investors with zero brokerage accounts who want to earn extra returns on their leftover cash.

Redemption Process in Liquid Funds

Withdrawing money from liquid funds is easy and flexible. Here’s how it works:

Typically, you can withdraw your money at any time without any withdrawal restrictions. Withdrawals are usually processed within the same working day or the next working day. Ensure you check the exact redemption process of your specific liquid fund, as this may vary between different mutual fund schemes.

Comparison with Savings Accounts

Liquid funds offer higher returns compared to savings accounts, but they come with some risks:

Higher Returns: Savings accounts typically offer interest rates around 4-5%, whereas liquid funds provide higher returns, typically around 7-9%. Risk: While the risk is low due to the short duration of investments, there is still a risk of NAV fluctuation. Liquidity: Liquid funds offer the flexibility to invest for as little as one day, whereas savings accounts usually require a longer fixing period.

Taxation on Liquid Funds

Taxation on liquid funds is similar to other debt mutual funds. Here are the details:

Short-term Capital Gains: If you sell liquid funds within three years (36 months), you will have to pay short-term capital gains tax. Short-term gains are added to your income and taxed according to your income tax slab. Long-term Capital Gains: If funds are held for more than three years, you qualify for long-term capital gains tax at 20% with indexation benefits.

Note that stocks are generally more tax-efficient, becoming completely tax-free after one year for long-term gains, and even short-term gains attract a lesser tax rate of 15%.

NRIs and Liquid Funds

The tax treatment of liquid funds is the same for Non-Resident Indians (NRIs) and Indian citizens, with a few important differences:

NRIs will pay both short-term and long-term capital gains taxes at the time of redemption. Indian citizens have the flexibility to redeem the full amount and then pay the taxes while filing their income tax returns (ITR). The Double Taxation Avoidance Agreement (DTAA) can help NRIs avoid double taxation on the same income in India and their resident country.

Conclusion

Whether you choose liquid funds or a savings account depends on your financial goals and risk tolerance. Liquid funds offer higher returns and greater flexibility, but they also come with some risk. Savings accounts are more straightforward with lower risk but lower returns. Always consult with a financial advisor to ensure you make the best decision for your specific circumstances.

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