Traditionally, when it comes to investing surplus cash for short to medium term, we have always looked to bank fixed deposits as a default choice. And historically in the absence of alternative choices and access to technology bank fixed deposits have become synonymous with safety and security with added benefits of secure fixed income.
What if all the above benefits are available in another investing instrument, with the same low risk, the same returns and same ease of investing and withdrawal? We are referring to liquid funds or ultra-short term debt funds. These are funds issued by all mutual funds houses and invest in ultra safe bonds and debt instruments such as Govt of India securities. The maturity of these instruments is up to one year, thus making these funds safer with extremely low volatility.
But what really sets liquid fund apart from bank deposits is the tax treatment of gains. Whereas the interest earned on a bank deposit is treated as income in totality and taxed, gains from liquid fund are treated as capital gains and taxed only when sold. Let us explain the difference through an example below:
Let us assume an investment of Rs 10 lakhs in either a bank FD or a liquid fund and compare tax treatment of the gains.
Bank FD: Assuming an annualized interest rate of 7%, interest income comes to Rs 70000 per annum. Assuming the client falls in 30% tax bracket, the post-tax yield works to Rs 49000 or 4.9% annually.
Liquid Fund: Liquid funds typically generate similar yields to bank deposits. Thus in our example an investment of Rs 10 lakhs will grow to Rs 10.70 lakhs at the end of the year in liquid fund.
Withdrawing Rs 70000 of gains at the end of the year is treated as sale value of capital asset and not as income in itself. Corresponding purchase cost, at 7% annualized yield, of this Rs 70000 is Rs 65420 approximately. Thus capital gain for taxable purpose is Rs 4580.
Short term capital gains on debt funds are taxed at 30% (assumed tax bracket of our client), i.e. Rs 1374 of tax. Post tax cash flow in investor’s hand is Rs 68626 (70000 minus 1374). Thus effective yield is 6.86% without taking any additional risk.
Following table provides a summary of above points:
| Fixed Deposit | Liquid Fund | |
| Principal (Rs) | 1,000,000 | 1,000,000 |
| Pre-tax annualised yield | 7.00% | 7.00% |
| Interest Amount (Rs) | 70,000 | 70,000 |
| Tax on interest (@30%)* | 21,000 | – |
| Capital Gain tax (@30%)* | – | 1,374 |
| Post Tax yield | 49,000 | 68,626 |
| Post Tax Yield % | 4.90% | 6.86% |
Further in case of bank deposits, tax is levied irrespective of whether the interest is withdrawn or not, in case of liquid funds, tax liability arises only when sold or liquidated. Thus clients can defer possible tax liability to future years especially when client does not need to withdraw cash.
Please get in touch with us to know how you can maximize yields on your fixed income portfolio at low to moderate levels of risk. We offer a Virtual HelpDesk for our clients, where you can request a free video consultation with us to answer your financial and investing queries.