Are Liquid Funds Tax Free?

The short answer? No. For the long answer, let’s understand how liquid mutual funds work and how liquid funds are taxed.

Due to their flexibility, mutual funds have become extremely popular among investors. Thanks to the availability of different fund types that suit investors with varying risk profiles, MFs are becoming more popular. Investors today are interested not only in the best fund to invest in, but also in the type of fund that is the most cost-effective to invest in.

However, investment decisions don't end at that. Besides the expense ratio, you also must pay taxes on your earnings from mutual funds. But not all funds are taxable. Let’s look at the different mutual fund options and who should invest in them.

Types of mutual funds

What are liquid mutual funds?

Liquid funds are debt mutual funds that invest in money market instruments with a short-term maturity of up to 91 days. These assets include government securities, commercial papers, certificates of deposit, treasury bills, repos, call money, etc. 

The returns on a liquid fund are based on the market price of these securities. These returns are more stable than other debt funds as prices of short-term securities fluctuate less than long-term bonds. 

Why should you invest in liquid funds?

If you have a short-term investment horizon and want to make the most out of your money, then liquid mutual funds are ideal for you. Here's how-

• Flexible investment period

A liquid fund allows you to hold your investment for as long as you want. This way, you can easily enter and exit the fund while enjoying safe returns that are linked to the market. But remember, if you redeem the funds within seven days, you'll have to pay a small exit load.

• Low risk

Liquid funds are debt funds with low risk. They focus on generating steady returns while keeping the principal amount safe. This keeps their value stable across other interest rate cycles in the market. 

• Low cost

The expense ratio forms a significant component in the final mutual funds' calculation. But the expense ratio of most liquid funds is below 1%. This is because they're not managed as actively as other debt funds. This reduces your cost of investment while maximising the returns.

• Quick Redemption

As liquid funds invest your money in highly liquid securities that have a low default rate, they process your redemption request instantly or within one working day. Therefore, in the event of an emergency, you'll not have to wait for days to access the funds.

Are liquid funds tax-free?

Now that we have understood the meaning and benefits of a liquid fund, the big question is- are they tax-free? Taxes are an important factor to consider for mutual funds calculation. When you invest in liquid funds, you earn dividends and capital gains. 

While your dividend income is tax-free, the income from capital gains is taxable. You will have to pay taxes on short-term or long-term capital gains based on the holding period.

• Short-term capital gains

When you invest in a liquid fund for up to three years, you'll earn short-term capital gain when you sell or redeem the units. For your mutual fund calculation, add the profit from the fund to your income. You will now have to pay taxes as per the rate of your income tax slab. 

• Long-term capital gains

When you invest in a liquid fund for more than three years, you will earn long-term capital gains. Before calculating the capital gain, you will receive the benefit of indexation. This means the fund will increase your purchase price to adjust for inflation before the final mutual fund calculation. Following this, your long-term capital gains will be taxable at a flat rate of 20%.

What is the best mutual fund to save on tax?

Although liquid funds provide you with great flexibility and a low cost of investment, they are not entirely tax-free. This makes them unsuitable for you if your primary objective is to save tax. But if not liquid funds, then what?

Well, the answer is ELSS mutual funds. These are open-ended funds that invest a majority of their corpus in equities and equity-related assets. ELSS allows you to make investments in a Systematic Investment Plan or SIP. With ELSS, you can avail of a tax exemption of up to Rs. 1.5 lakh on your annual income under Section 80C of the IT Act.

Types of ELSS mutual funds

ELSS funds are of two types depending on the investment system and return pay-out. These are-

• Growth plan

You can invest in this plan through SIPs and realise the full value of the fund after you redeem the units. This means that after the lock-in period ends, you will receive the returns in a lump sum.

• Dividend plan

Under this plan, although you can't redeem the units before the lock-in period ends, you receive a tax-free dividend income. You can choose to either receive the regular dividend pay-out or reinvest it into the fund.

Benefits of ELSS funds

• It's the only MF category that offers tax-saving benefits.
• It diversifies your portfolio by investing in stocks across industries and capitalisations.
• It's equity-oriented and therefore offers higher returns than other tax-saving instruments.
• It's a SIP that helps you save taxes with small and regular investments.

The bottom line

Taxes play a significant role in mutual fund calculation. While MFs are an excellent and safe investment instrument, taxes can reduce their returns. With ELSS funds, you can not only increase your wealth but also enjoy taxation benefits. Additionally, long-term capital gains on ELSS up to Rs. 1 lakh are also exempt from income tax.

ELSS also offers higher returns than FD or PPF, but you must have a high-risk appetite to invest in it. You can download the Tata Capital Moneyfy app to compare investment options and manage your portfolio smoothly.