Liquid Funds as an alternative to Saving Deposits

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This is a guest post by Ankit Jaiswal @kredentacademy.

The Liquid funds, also popularly known as Money Market funds, are an investment tool to earn interest or return. As the name suggest, liquid funds represents highly liquid debt securities. Essentially these are low risk- highly liquid investment into fixed interest bearing instruments like Treasury bills, Commercial papers, certificate of deposits etc. with maturity as low as of upto 91 days. So as such, the liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted into cash is similar to cash itself because the asset can be monetized with little impact on its value.

Rationale for investing in liquid fund

Post Demonetization and the thrust on digitization, it is imperative to understand how efficiently and effectively one can use liquid funds. As an individual, one can invest in liquid schemes that are being offered by various Mutual Fund houses. A liquid fund’s purpose is to provide investors with a safe place to invest in easily accessible & cash-equivalent assets. It is a type of scheme that is characterized as a low-risk, low-return investment. However one has to always keep in mind that he/ she will not see significant capital appreciation in liquid fund investments.

Aside from being low risk and highly liquid, liquid funds may be attractive to investors because they have no entry or exit loads. From liquidity aspects, one can redeem entire amount or part of the amount from liquid fund at any point in time. Even from a regular income perspective, liquid fund offers options in terms of dividend payout which can be daily/ weekly/ monthly, depending on the need of the investor. If investor does not want to cash out dividend, he/ she can opt for growth option.

Liquid fund is an alternate to saving account

As the concept of Financial Planning is gathering more and more acceptance, the awareness about various products offered by mutual funds are also increasing. Earlier mutual funds were recognized for Equity dedicated schemes. Now the debt products of mutual funds are also becoming popular. Individuals use to keep the surplus money either in saving account or in FDRs; however liquid funds have evolved as a strong alternative to the saving bank account and to some extent also to the Fixed Deposits (FDRs).

Historically saving accounts are the most popular instrument which offers the flexibility to deposit and withdraw money at any time. The interest on saving account varies from 4%-6%. The interest paid is tax free upto the limit of Rs.10,000 per year. Anything over and above the limit is added into the annual income and is taxed as per the respective slab.

Liquid funds as explained above are managed by mutual fund companies. The liquid fund carries the minimum risk as the instruments are of very short term and thus it eliminates the volatility risk. There is no lock in period for investment in liquid funds. Also the redemption/ withdrawal request are executed within 24 hours by the fund houses. With advent of digitization and online transaction, one can use their ATMs for investments into and withdrawals from Liquid funds.

To summarize;

Liquid Scheme Saving Account
Returns In range of 7%- 8%; tend to give 150 – 200 bps higher than saving account In range of 4%- 6%
Risk Interest is market risk. Risk is higher than saving account Although a bank revises interest rates but generally stable and risk is negligible
Withdrawal No lock in. investor can exit from liquid fund at any point in time, even on next day from investment No lock in
Taxation Not tax free but at best tax efficient Taxable

 Who can invest in liquid funds?

 Anyone, being an individual or a corporate house, can invest liquid funds. However one has to keep in mind that liquid funds are meant to use available idle funds more effectively & efficiently. So if an individual is holding small amount of say Rs. 10,000 or 50,000, liquid fund may not be that effective.

Let us look at an example of how effectively one can use liquid funds.

Say Mr. A received huge inflow of Rs. 1 Crs on maturity of his LIC policy. Now it may not be possible as well as practical to invest all these funds at one go. So a likely scenario would be that he will be keeping this fund in his saving account till he decides his plan of action on further investment.

Since these funds are idle with no immediate use, it will give him meager 4% interest on his saving account. In such scenario, liquid funds plays important role. Here he can immediately shift to liquid fund which will give him better returns compared to saving account interest. Once he deploy money into liquid fund, he can gradually decide to invest in any other asset class like equities, real estate or any other investment scheme of mutual fund.

On the same lines, if a corporate house receives some big inflow or receivable and there is no immediate use expected of the funds, the Company can immediately shift funds from their current account (which yields no interest) to any liquid fund and start earning interest on the same.

Taxation

Let us understand the taxation aspect in details. With changes in the tax laws for the debt instruments, the arbitrage opportunity that debt product used give have diminished

Tax impact Liquid Schemes Savings Account
Short term gain (if amount redeemed within 3 year) Long term gain (if amount redeemed after 3 year)
Capital appreciation As per the income tax slab applicable to investor 20% (with indexation benefit) NA
Dividend/ Interest Income 28.84%; fund house deduct this tax and pays net amount to the investor. No tax upto Rs. 10,000. Over and above- as per the income tax slab applicable to depositor

Illustration:

Let us look at an illustration on the tax impact on the investment made in liquid fund and money kept in saving account. We have assumed that the individual is in the highest, i.e., 33% tax bracket

Mode of investment Amount of Investment (Rs.) Interest Rate (%) Tax Rate (%) Pre Tax Return (Rs.) Post Tax Return (Rs.)
Saving Account 400,000 6% 33% 24,000 16,080
Liquid Fund (Dividend Payout option) 400,000 8% 28.84% 32,000 22,771
Liquid Fund (Growth option) 400,000 8% 33% 32,000 21,140*

Note*: here we have assumed highest tax rate. In practical case, the tax rate can be adjusted for indexation benefit.

To conclude, liquid funds extend the advantage of better returns when compared with saving account with basic principal of capital safety and easy liquidity. Hence, it is advisable to park surplus funds into liquid mutual funds.

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