How are Liquid Funds Taxed?
As the name suggests, liquid funds are mutual funds that guarantee liquidity in a jiffy! Believe it or not, liquid MFs are so flexible that you can invest in them even for a day should you so wish! Investors can avail of indexation benefits on capital gains through the long term from liquid mutual funds. Mutual funds help investors to increase their savings and also accumulate inflation-adjusted returns.
However, liquid fund returns are considered to be income and are taxable. The tax that you need to pay on your liquid funds will depend on the nature of the securities the fund has chosen to invest in and the holding period of the fund. We look deeper into how liquid MFs are taxed.
Taxation and Mutual Funds
For any mutual fund you invest in, when a fund invests 65% or more of its reserves in equities, it is called an equity-based fund. This means that debt funds that invest a portion in equities are taxed as equity-based funds. The balance portion of reserves is pumped into either liquid funds, gold funds, or even fixed maturity funds. These are then taxed as debt funds. When it comes specifically to liquid funds, here is how they are taxed.
Dividend Taxing
When you invest in liquid mutual funds, you have a couple of options to choose from. You can either select funds that incorporate dividend payouts or ones that generate capital gains. If you have chosen the former, the dividends will be paid to you from the income and profits earned by the fund. Typically, dividend payouts are considered income and require to be taxed. However, the Government of India has removed the Dividend Distribution Tax in the Union Budget 2020. Therefore, the dividends earned on liquid MFs as well as debt funds are completely tax-free!
Taxing on Capital Gains
Liquid funds are taxed as debt funds because they are non-equity. When they are owned for a period lesser than three years, the gains are considered to be Short Term Capital Gains or STCG. For funds owned for a tenure of over three years, the gains are considered to be Long Term Capital Gains or LTCG. Long-term capital gains attract 20% tax and there is the indexation benefit on offer for investors. Indexation benefit is the recalculation of the price at which the fund units have been purchased for adjusting to inflation and thereby reducing the taxation impact on long-term capital gains.
When it comes to short-term capital gains, the liquid fund returns are added to the investor’s regular income and taxed according to designated income slabs. So, as an investor, if you come under the 30% slab, the peak tax would be 30% and if you are in the 20% slab, you will pay taxes at 20%.
Liquid MFs are ideal additions to your investment portfolio if you are seeking instant liquidity and impressive returns. Whereas short-term investments can attract hefty taxes you can easily increase your investment tenure by reducing the tax component.
