Liquid Funds Taxation: How to Optimize Returns after Taxes

In simpler terms, Liquid Funds are debt funds. With the only difference being that the LF investments mature within a period of 91 days. These invest your money in very Short-Term Money Market Instruments having Fixed Interest rates. These can be treasury bills, government securities, commercial paper, etc. Therefore, these Mutual Funds Investments hold the least amount of risk. As a result, Liquid Funds are the least risky Debt Mutual Funds.

Investing in Liquid Funds can get you higher returns than Bank Deposits as the returns are linked to the market. Therefore, many investors prefer Liquid Funds from Bank Deposits. But do keep in mind the Liquid Funds Taxation before diving into it.

As per the Income Tax Act, if you sell your funds within a period of 36 months (3-years), you will have to pay Short-Term Capital Gains Tax. Following this, the Returns under the Liquid Fund Taxation is considered at the Income Tax Slab Rates.

Whereas, if you hold your Mutual Funds Investment for more than 3-years. Then your gains will qualify for Long-Term Capital Gains (LTCG) Tax of 20% with indexation benefit.

Understanding Liquid Funds Taxation

Similar to investing in other Mutual Funds, you also have the option to choose to invest for Growth or Dividend. Liquid Funds Taxation differ accordingly.

Suppose you have chosen to invest in the Growth Plan. Now, if you redeem units before the 3-years are over, then you have to pay short term tax returns which will be taxed at slab rates. Whereas, if you redeem units after 3-years then you have to file LTCG Returns. They include indexation benefits and are taxed at a rate of 20%.

On the other hand, if you choose to invest in the Dividend Plan. Thereby, all Dividend Funds have a Dividend Distribution Tax (DDT). As a result, Dividends declared are not taxable in the hands of the individual. But then all non-equity funds attract the DDT of 28.84%, which is deducted. And afterward, you get the Tax Deducted Amount.

The Right Option to Invest

You can opt to keep your surplus money in your Bank Account itself. If you want to completely avoid taxes. Interest earned on your Saving Bank Account, up to Rs. 10,000 is exempt under Section 80TTA of the Income Tax Act.

For instance, take an LF with a 7% Return. The Actual Returns, after Liquid Funds Taxation, will be 6.3%, 5.6%, and 4.8%, respectively, for individuals belonging to the 10, 20 and 30% tax bracket.

This is higher than the 4% interest that most banks offer. A few banks may offer a bit higher interest rates, on high-value deposits. That maybe 5-6%.

Then again, if you hold over Rs. 2.5 lakh in your savings accounts. Liquid Mutual Funds still score better by offering better returns.

In case you come under the 10-20% Tax Bracket. Then, you can opt for the Growth option rather than the Dividend option. Because the effective Tax rate will be lower under the Growth option.

Now, if you belong to the 30% Tax Group. the Dividend option (after considering the DDT at 28.84 percent) may be a better choice as any redemption before 3-years will attract a Tax rate of 30.9%.

If, however, you are earning beyond Rs. 1 crore, the Tax Bracket will include the Surcharge. Accordingly, the Short-Term Capital Gains Tax will be higher at 35.53% due to the surcharge of 15%.

The Right Time to Invest

Of course, you must have heard about LF being the ideal parking grounds when you have a suddenly received money. It may be from a legal settlement or in between 2 investments.

Even though, the LF cannot fully substitute savings in a Bank Account. You can not instantly withdraw, using your ATM Card. Except for a few Funds.

However, when you consider the Low-Interest Rates of about 4% of Savings Account. And 7-8% Returns from LF. You would choose the higher option yourself.

Above all, you can choose to exit the LF anytime with Nil Exit Load and receive your money the next day.

Another way to make a good LF investment is if you invest in them and then do a Systematic Transfer to the Best Equity Funds you may choose. You may have chosen the SIP route to invest in Equity Funds. That is preferable if you are investing out of your monthly savings. But in situations of receiving a large sum, you can use LF. This increases your Returns.

When Not to Invest in LF

If you are looking to invest in very short term mutual funds, for a matter of a few days, do be careful investing in the Dividend Plan. Whether it be the monthly, quarterly, half-yearly or yearly options. You must check the Record Date carefully. If you purchase the units just a few days before the Record Date, it can leave you with a loss at the time of redemption.

Because the NAV of the Mutual Funds falls to the extent of the total Gross Dividend after the payout is declared. But the Net Dividend you will receive is after deducting the DDT. Therefore, you will be getting only 71.16% of the Dividend declared. Above that, the NAV will get adjusted to the extent of the Gross Dividend. And you will have to bear this loss in capital.

Time for Entry & Exit

The best option for you would be to stay invested for at least a period of 10-days. In case you chose the Monthly Dividend Option.

Or at least 25-days, if you chose the Quarterly Dividend Option.

Lastly, if you invested in the Half-Yearly or Yearly Option, you should stay invested for a longer period accordingly. This way you would be able to cover your loss of capital.

Besides the above, you could also invest in the Daily Dividend Payout Option. Here, the NAV will not fluctuate much on a day-to-day basis.

Do note that is you invest in the same monthly or quarterly dividend option, post the record date, will not lead to a capital loss. Hence you can redeem at any point in time.

If you can keep the investment for over 3-months, say 6-9 months or beyond– then you can consider going for Ultra-Short Term Funds. Invest in these funds in one go as you need not worry about timing the market.

Indexation Benefits for optimizing Liquid Funds Taxation

Liquid Funds Taxation: Indexation Benefits: WealthBucket

If your Risk Appetite is Low or Low-Moderate and can invest for a period of over 3-years. Then you can invest in the Growth Option. The Gains received at the time of redemption will attract Liquid Funds Taxation of 20% with Indexation.

Indexation would mean that the Cost of Investment and the Redemption Amount get adjusted according to the Inflation Index. Afterward, it is taxed. Thereby, in most cases, after a period of 3-years and more, this becomes almost Nil. Sometimes the calculation becomes negative, as well. This may get carried forward to be considered against other LTCG, conditionally.

This indexation benefit is not available on Bank FDs or other Tax Saving Investments.

How to save on Liquid Funds Taxation

It might seem that the Liquid Funds Taxation will take away any gain on your investment. That these are not good tax saving instrument as they suffer from short-term capital gains tax (at your regular tax slab) if held for less than a year. Especially if you belong to the higher Tax Slot, it would hurt.

But you can handle this in a far more effective way. You can opt for Dividend Re-investment. This way the Dividends will get reinvested as Units and fresh investments. With a low NAV, the Dividend and Reinvested Units will get considered as a fresh cost. Thereby your capital gain (sale cost) will get almost nil or very low.

Moreover, if you hold your LF for more than a year, in such a case you may go for the Growth Plans. This way you will be liable for Indexation benefits.

LF invest in securities with a duration of up to 91 days. As soon as their existing securities get mature, these schemes buy new papers getting higher interest rates. Automatically, their average 1-year return will become better than FDs.

Some Suggestions to Invest

We are giving below a list of Liquid Funds that have done well in recent years. The Funds in this list come with a Low Expense Ratio. And have earned at least 7% Average Returns. Their Portfolio consists of bonds with the least maturity, therefore, less volatile.

The Returns provided in the above table are as per data available on March 31, 2019. Moreover, it is important to note that the Returns earned in the past couple of years may not be replicated, in case the interest rates fall.

 

Liquid Funds Taxation is a significant aspect of investing for short terms. Still, they may yield better returns than saving in banks.

1. The AMCs and MF Houses make sure to invest in instruments with high credit rating (P1+).
2. Unlike other funds, the NAV of LF does not fluctuate easily as the only change in their NAV is mostly as a result of the interest income that accrues. To put it simply, because of their short-term maturities, these instruments are hardly traded in the market. They are held until maturity. Hence, their NAV will only fluctuate to the extent of interest income accrued, every day, including weekends.

For more advice by experts for investing in Liquid Funds, visit WealthBucket. We provide services like investing Equity mutual funds, Multi-cap mutual funds, Large cap mutual funds or Small-cap funds & many more. Instead of visiting our website you can also call us at +91 9999379929 or email us at contact@wealthbucket.in.

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