Taxation on Liquid Funds in India

Mutual funds have gained immense popularity among investors, with liquid funds standing out as a preferred choice for those seeking stability and liquidity or easy access to their money. However, dividends and returns on these funds come with specific tax implications. Understanding these tax rules is essential for optimising returns and making well-informed investment decisions.

Let’s understand how liquid mutual funds work and how they are taxed.

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. 

Taxation on Liquid Funds

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%.

Advantages of Investing in Liquid Funds

Investing in liquid funds offers several advantages. Key advantages include:

• Low risk: Liquid funds invest in short-term, high-quality debt instruments, making them relatively low-
  risk compared to other mutual fund categories.
• Cost-effective: These funds have lower expense ratios compared to other mutual funds, reducing the
  impact of fees on returns.
• Flexibility: You can easily redeem your investments within 1-3 days, making them highly liquid.

Who Should Invest in Liquid Funds?

Liquid funds are suitable for the following types of investors:

- Short-term investors

Liquid funds are ideal if you have a short investment horizon, typically ranging from a few days to a few months. invest in short-term money market instruments like treasury bills, commercial papers, and certificates of deposit, which offer relatively stable returns with minimal interest rate risk.

- Investors who invest in bank deposits

If you only invest in bank deposits, you can benefit from liquid funds due to potentially higher yields. While bank deposits are relatively safe, liquid funds offer competitive returns with added flexibility. They also provide the advantage of immediate redemption and typically do not have a lock-in period.

- Investors who want to maintain emergency funds

Liquid funds are ideal for investors looking to maintain an emergency fund. These funds can help cover unexpected expenses without compromising on returns. Moreover, liquid funds offer quick and easy access to funds, ensuring you can withdraw money whenever needed without any penalties or waiting periods.

- Temporary parking of funds

You can use liquid funds as a temporary parking space for funds. Whether you're waiting for an investment opportunity or in between switching to a different investment, liquid funds provide a safe haven with stable returns.

- Medium-term investment route

Some investors use liquid funds as a bridge between equity investments and safer options. When transitioning from stable investments to equity funds, liquid funds serve as an intermediary step. They provide a buffer against market volatility while offering better returns compared to traditional savings options.

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.

Conclusion

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.

FAQs for Liquid Fund Taxation

Are liquid funds safe?

Liquid funds are considered relatively safe because they primarily invest in short-term debt securities, minimising risk. However, like all mutual funds, they are subject to market risks.

Do liquid funds have a lock-in period?

No, liquid funds do not have a lock-in period. You can redeem your investments anytime without any penalty.

Do liquid funds have an exit load?

Some liquid funds may have an exit load if redeemed within a very short period after investment, typically up to 7 days. However, many liquid funds do not impose an exit load.

Are liquid funds better than fixed deposits?

Liquid funds offer higher liquidity and potentially higher returns than fixed deposits over the short term. However, they also carry market risk compared to the guaranteed returns of fixed deposits.

How are liquid ETFs taxed in India?

Liquid ETFs are taxed similarly to debt mutual funds. Short-term capital gains are taxed at applicable slab rates, and long-term capital gains are taxed at 20% with indexation benefits.

Is there any tax on liquid funds?

Yes, liquid funds are subject to taxation. Short-term capital gains are taxed at applicable slab rates, while long-term capital gains are taxed at 20% with indexation benefits.

How much dividend income is taxable on a liquid fund?

Dividends from liquid mutual funds are taxed as per the investor’s income tax slab, with a 10% TDS on amounts exceeding ₹5,000.

What is the TDS on dividends from Indian companies? 

Dividend incurred by Indian companies are subject to 10% TDS if the total dividend received surpass ₹5,000 in a financial year.