Liquid Funds
Liquid funds are popular in India because they are safe, offering quick access to cash and better returns than savings accounts. They invest in short-term instruments and offer higher returns than savings accounts, making them ideal for short-term extra funds. Their quick redemption and stability attract investors seeking flexibility and security.
What Is Liquid Fund?
A liquid fund is a type of debt mutual fund that invests mainly in short-term, highly liquid financial market instruments such as treasury bills, commercial papers, and certificates of deposit. The liquid mutual funds offer investors low-risk returns with high liquidity and quick redemption, typically within 1-3 business days.
Liquid funds offer high liquidity, allowing investors to withdraw their money quickly, often within 24 hours. This makes them ideal for storing surplus funds temporarily while earning better returns than a regular savings account. Additionally, liquid funds typically do not have an exit load if redeemed after seven days.
Liquid funds are a subcategory of debt funds. Liquid funds invest in short-term instruments for low risk and quick access, while debt funds invest in bonds and fixed-income for higher returns but more significant risk. Liquid funds are suited for short-term cash saving, while debt funds fit longer investment objectives.
How Do Liquid Funds Work?
Liquid funds work by investing in short-term, high-quality money market instruments. These instruments have periods of up to 91 days, ensuring minimal risk and low volatility. When you invest in a liquid fund, the fund pools your money with that of other investors and allocates it across various short-term securities.
Liquid funds earn through interest payments on the instruments they hold and capital appreciation when the securities are sold at a profit. The returns are stable, reflecting short-term interest rate movements in the market.
Liquid Fund Taxation
Tax on Liquid Funds in India is based on capital gains, which are categorized as short-term or long-term depending on the holding period:
Short-Term Capital Gains (STCG):
When you hold liquid fund units for up to 3 years, any gains you make will be added to your total taxable income and are taxed according to your income tax slab rate, which means higher income earners may pay more tax on these gains.
Long-Term Capital Gains (LTCG)
For liquid fund units held for more than 3 years, the gains are taxed at 20% with indexation benefits, where the purchase price is adjusted for inflation to reduce your tax liability and provide more favorable tax treatment compared to short-term gains.
Dividend Income
All dividends received from liquid funds become part of your total taxable income for the year and are taxed based on your applicable income tax slab rate, making it essential to consider the tax implications when choosing between dividend and growth options.
Tax Deducted at Source (TDS)
While there is no TDS on capital gains from selling liquid fund units, a 10% TDS is applicable on dividend payments when your total dividend income from mutual funds crosses ₹5,000 in a financial year, though this can be claimed as a credit when filing your tax returns.
Liquid Funds vs FD
Liquid funds offer flexibility and quick access to cash, while fixed deposits provide stable, guaranteed returns. This table outlines the key differences to help you decide based on your financial goals.
| Feature | Liquid Funds | Fixed Deposits (FD) |
|---|---|---|
| Risk Level | Low (but not risk-free) | Very Low (almost risk-free) |
| Returns | Market-linked can vary | Fixed and predetermined |
| Liquidity | Highly liquid, redeemable within 24 hours | Limited, premature withdrawal incurs penalties |
| Tenure | No lock-in, flexible holding period | Fixed tenure (ranging from 7 days to 10 years) |
| Returns Rate | 4-7% (subject to market) | 5-7% (depends on tenure and bank) |
| Tax Type | Capital gains | Interest income |
| Safety | Relatively safe, but market fluctuations apply | Highly secure, covered by DICGC (up to ₹5 lakh) |
| Accessibility | Easily bought or redeemed online | Requires a visit to the bank or online booking |
| Best For | Short-term surplus money, emergency funds | Guaranteed returns over a fixed period |
Secure your future with the right funds. Dive into expert insights on alternative funds that can help safeguard and grow your savings.
Who Should Invest Liquid Funds?
Liquid funds are suitable for various investors who prioritize liquidity, safety, and short-term returns. Here are five key profiles of individuals and groups who should consider investing in liquid funds:
Extra Money Management
This is an alternative for individuals who have extra funds on hand that are not immediately required. Liquid funds provide better returns than savings accounts while keeping the money easily accessible.
Emergency Fund Builders
Liquid funds work great for emergency savings since you can access money within 24 hours. They offer better interest than regular savings accounts while maintaining easy access to your funds when unexpected situations arise.
Risk-Averse Investors
If you prefer to take a cautious approach with your investments, consider liquid funds. They invest in low-risk, short-term options. Your funds stay protected while earning steady returns, making it ideal for those who want to avoid market risks.
Businesses and Corporates
Companies can use liquid funds to store their extra cash while earning returns and keeping it available for business needs. It’s a more intelligent alternative than allowing funds to remain inactive in business accounts.
Short-Term Goal Planners
When saving for near-future goals like vacations or purchases, liquid funds offer steady growth without major risks. They help you reach your targets while keeping your money safe and accessible.
How to Choose the Right Liquid Funds
Choosing the right liquid fund involves evaluating factors that ensure safety, liquidity, and optimal returns. Here’s how to make the right choice:
- Fund Portfolio Quality – Look for funds that invest in high-quality, low-risk instruments like treasury bills and commercial papers with high credit ratings. This reduces the chances of default and ensures stable returns.
- Expense Ratio – Consider liquid funds with a low expense ratio, as this directly affects your returns. Lower costs mean more of your earnings stay with you.
- Past Performance – Review past performance to gain insights into how consistently the fund has performed during different market conditions. However, remember that it doesn’t guarantee future returns.
- Redemption and Liquidity – Choose funds that allow easy and quick redemption, typically within 24 hours, without additional charges or penalties.
- Fund Size and Reputation – Choose larger funds managed by reputable asset management companies (AMCs) for better safety, as they often provide stronger risk management and diversification.
If you’re interested in exploring more mutual fund options, explore our other articles where we review top-performing mutual funds and provide tips on selecting funds across different categories.
FAQs
Liquid funds are mutual funds that invest in short-term, high-quality debt instruments such as treasury bills and commercial paper. They provide high liquidity and low risk, making them suitable for storing surplus funds for short durations.
The average return on liquid funds typically ranges between 3.5% to 6% annually, depending on market conditions and the prevailing interest rates. While 7% can occasionally occur, it’s on the higher side, not the average.
Key factors include the fund’s expense ratio, past performance, credit quality of investments, asset size, and fund manager’s experience. Look for funds with low risk, stable returns, and high liquidity.
Compare historical performance over 1-month, 3-month, and 1-year periods. Consistency in returns is more important than short-term outperformance.
Yes, consider investing in funds that focus on top-rated securities like AAA bonds, which can help protect your portfolio from credit risk. High-rated instruments indicate a lower probability of default.