Liquid Funds Taxation

Get to know more about the tax on liquid funds

Key Takeaways

Liquid Fund is a class of debt fund that with maturity tenures of up to 91 days.
A type of Debt Fund, Liquid Funds, are taxable.
Dividends earned from a Liquid Fund is exempt from tax.
Short-term and long-term capital gains are taxable, per investors' income tax slabs.

Investors can enjoy indexation benefits on long-term capital gains from Liquid Funds.Today, investors prefer to invest their savings than accumulating marginal returns in a Savings Account. Mutual Fund investments help investors grow their savings and earn inflation-adjusted returns. However, earnings from Mutual Fund investments are considered as income and are therefore taxable. The tax payable on a Mutual Fund scheme will depend on the type of securities the fund invests in and the holding period of your investment. Learn more about Liquid Mutual Funds Taxation in this article.

What is a Liquid Fund?

A Liquid Fund is a Debt Mutual Fund that invests in short-term securities such as Treasury bills, repurchase agreements, commercial papers, government securities or certificates of deposit. The SEBI mandates that highly liquid funds should strictly invest in debt and money market instruments. Liquid Funds offer a maturity period of 91 days with no lock-in period.

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A general thumb rule for any Mutual Fund is that if the fund invests 65per cent of its assets in equities, that fund is considered equity-oriented for taxation. Therefore, even Debt Funds that invest a part in equities are taxed as such. The remaining portion of assets are invested in fixed maturity plan funds, Gold Funds or Liquid Funds and are then taxed like Debt Funds. Now let us learn more about the tax implications on Liquid Mutual Funds only.

Tax on Dividends

When you invest in Liquid Funds, you can choose funds that pay dividends or funds that yield capital gains. If you opt for the former, the fund pays dividends from the profits and income earned. Ideally, a dividend is a form of income that requires taxpayers to pay income tax. However, in Budget 2020, the Government abolished the Dividend Distribution Tax. Hence, dividends earned on Debt Funds or Liquid Funds are entirely tax-free.

Tax on Capital Gains

Liquid Fund is a non-equity fund. Therefore, it is taxed similarly to a Debt Fund. When held for up to three years, Liquid Fund gains are referred to as Short-Term Capital Gains (STGC). For Liquid Funds held for more than three years, the gains are known as Long-Term Capital Gains (LTGC).

LTGC for Liquid Funds is taxed at 20 per cent , and investors can avail of the indexation benefit. Indexation benefit refers to the recalculation of the purchase price to adjust for inflation, reducing the impact of tax on LTGC in Debt Funds.

For short-term gains, the Debt Liquid Fund gains get added to the regular income and are taxed as per the investors' income tax slabs. If you, as an investor, fall under the 30 per cent slab, your peak tax would be 30 per cent , whereas, for a 20 per cent slab, you would pay tax at a 20% rate.

Conclusion

Liquid Funds are an ideal addition to your investment portfolio if you want to add a short-term investment instrument. Although taxable, you can avail of tax benefits by holding Liquid Funds for longer investment horizons.

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*Disclaimer: This article is for information only. We recommend you get in touch with your income tax advisor or CA for expert advice.