Liquid Fund VS Savings Account – Which is Better?

With the increase in the popularity of Financial Planning and its users, the awareness about mutual fund products has also increased. Specially, the debt mutual funds schemes have emerged as an alternative to the short term saving products offered by banks. Liquid funds are no brainier for companies as they earn no interest in their current accounts. Individuals use to keep the surplus money either in saving account or in Fixed Deposits; however liquid funds have evolved as a strong contender to the saving bank a/c and to some extent also to the fixed deposits. But with the recent changes in the tax structure of Debt Mutual Funds, are liquid fund scheme still better alternative to bank accounts? Before we delve into it, let’s first understand more about Liquid Funds.

Liquid Mutual Funds 

Liquid funds are open ended debt mutual fund schemes which invest into short term money market instruments without any exit load. The focus of Liquid fund is to generate return by maintaining highest liquidity with minimum risk in short term.

How liquid funds are different from saving account?

Saving accounts are the most popular instrument in which people keep their savings for day to day needs or short term parking. These are maintained by banks and post office where people have the flexibility to deposit and withdraw money at any time. The interest on saving account varies from 4% to 7% and 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. Other debt funds have instruments with longer maturity which carries interest rate volatility risk. There is no lock in period for liquid funds and on withdrawal request the funds are transferred within 24 hours. Also one of the Mutual Fund Companies offers the facility of ATM linked with fund, so at any time investor can withdraw the funds & few other provide SMS facility to transact. Liquid funds are available with different investment options like Daily Dividend, Weekly/Monthly Dividend and Growth option.

Tax implication on Liquid Funds:-

In his first budget on 10^thJuly 2014, the newly appointed Finance Minister has made some changes into tax structure of Debt Mutual Funds Schemes. Now the LTCG on debt fund is 20% with indexation and the 10% without indexation option is withdrawn. He has also increased the minimum investment period for being considered long term from 12 months to 36 month. This was done to avoid the arbitrage opportunity available to debt fund investors over bank FD’s.

Also, under the dividend option the government has given the new formula to calculate the effective rate of Dividend Distribution Tax due to which now investors will pay 6.255% more tax. (Individual resident & NRI (tax on distributed income) = 25% + 12% surcharge + 3& cess = 28.84% – for Domestic Companies its 34.608%)

Under the growth option the investor is charged as per holding period (i.e. LTCG and STCG).

LTCG: Long Term Capital Gain,    STCG: Short Term Capital Gain.

Under Dividend option the mutual fund company is charged with Dividend Distribution Tax (individual) as per below table:-

Is it still better to keep money in Liquid Funds than bank account?

Nobody will park their money in liquid funds for 3 years so in that scenario short term capital gain or dividend distribution tax will be applied to investor. The liquid fund has generated better returns than bank account in the past and hence it has emerged as better alternative. However, with the recent changes in the taxation policy the investors will pay more tax on the returns generated. Let us understand this with the help of the below table which shows the interest earned on the investment of Rs.5,00,000 each in liquid fund and saving account for two different person who comes under 20% and 30% slab respectively.(We are assuming that investor already consumed Rs 10000 tax benefit on saving bank interest – so a Rs1.5 lakh average balance in saving bank account generating 6%)

*Assuming person has invested Rs.5,00,000 for 1 year, who falls under the tax bracket of 20%.

*Assuming person has invested Rs.5,00,000 for 1 year, who falls under the tax bracket of 30%.

8% returns from liquid funds are on higher side but hardly any bank is giving 6% interest on savings account  If your bank is paying only 4% – difference will be huge.

Are you keeping too much in Savings Account?

It is clear from the above tables that investment into liquid fund has generated better post tax return than of saving account even after the recent tax changes. However, while investing into liquid funds, please note that if you fall under 20% or 30% tax bracket, you may have to select the suitable option i.e Dividend or Growth, as the investor falling under 20% tax bracket will earn more under growth option and investor falling under 30% will earn more under dividend option. So, the idea of keeping the emergency fund or surplus money into liquid funds is worth exploring as it offers the combination of safety, liquidity and better returns. (you should also compare returns/flexibility of ‘sweep in’ accounts with Liquid Funds)

Rolling Returns of Liquid & Liquid Plus (ultra short term) Funds

*Ultra short term funds have bit higher tenure & mark to market component.