Mutual funds are a popular investment option in India. There are two main types of mutual funds i.e., Equity Funds and Debt Funds. Debt funds invest in various debt instruments making them less volatile compared to Equity Funds. There are various types of debt funds such as Overnight Funds, Liquid Money Market Funds, Ultra-Short Duration Funds, Low Duration Funds, Long Duration Funds, Corporate Bond Funds, Credit Risk Funds, etc. Each of these funds caters to the different needs of investors.
The aim of the fund manager of a Liquid Fund is to invest only in liquid investments with good credit ratings with a very low possibility of default. They typically invest their corpus in a short duration bonds. This makes Liquid Funds an ideal solution for an investor to park their lumpsum money for a short duration. However, there is a tax implication when you buy or sell these funds. In this article, we will discuss taxation on Liquid mutual funds with examples to make it easier for you to understand the process better
Liquid Mutual Funds invest predominantly in highly liquid money market instruments and debt securities of very short tenure and hence provide high liquidity. There are two ways how investors earn by investing in mutual funds. One is receiving periodic dividends and the other is capital gains. Dividend from a mutual fund is taxable at investors’ current marginal tax rate. Capital gain(loss) tax arises when the investor sells his/her units of the mutual fund. Based on the duration when an investor sells his/her units two types of capital gains arise.
If an investor sells or redeems the units of a liquid fund after a holding period of up to 3 years, he or she is deemed to have earned short term capital gains. This is taxed at the income tax slab rate applicable to the investor.
If a liquid fund is redeemed/sold after being held for more than 3 years, the capital gain is treated as a long-term capital gain, and the investor gets the benefit of “indexation.” This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. Long term capital gains are currently taxed at a rate of 20%.
As per changes in Finance Bill 2023(Budget 2023), new investment in debt fund after 31st March 2023 is no longer eligible for LTCG and indexation. This means the realised gains on debt fund will be charged at the investors current tax bracket. However, your investments done up to 31st March 2023 will continue to enjoy LTCG with indexation benefits.
As the income generated from Liquid Mutual Funds is taxable for investors at his current tax slab, one may ask is there any advantage to investing in Liquid Funds? Well, there are multiple advantages.
You are taxed only when you redeem your units or receive dividends. Unlike bank accounts or Fixed Deposits (FD) where you need to pay tax even when you don’t receive interest on your fixed deposits in your hand. Also, when you receive interest, it is subject to TDS. So, your overall yield reduces on your investment, and you lose out on the compounding benefits of earning interest on interest.
Your capital gains/losses can be combined with your overall capital gains or losses from equity investments. This effectively helps you to reduce your overall tax liability by doing what is commanly know as tax harvesting.
One of the biggest advantages offered by liquid funds in diversification. When you make fixed deposit in a bank you are putting up all money in one single bank. Whereas when you put any money be it as little as five thousands, it gets diversified across multiple high quality bonds.
Liquid funds combined with flexibility and tax efficiency offer excellent investment options for Indian investors to park their lumpsum money. Changes in Finance Bill 2023 (Budget 2023) took away a bit tax advantage of liquid funds, but they still continue to offer very good alternative to bank deposits.