Understanding the tax implications of liquid funds

Liquid mutual funds invest in debt and money market securities, treasury bills, etc. with maturity of up to 91 days only. Being a type of debt fund, liquid funds offer investors a relatively stable way of generating potential returns on spare cash or an emergency corpus.

However, like all investment avenues, returns from liquid mutual funds are subject to taxation.

• Table of contents

1. What are liquid funds?
2. How do liquid funds work?
3. Tax implications on liquid funds
4. For liquid fund units acquired before April 1, 2023
5. For liquid fund units acquired after April 1, 2023

What are liquid funds?

Liquid funds are mutual funds that invest in short-term debt and money market securities with a maturity of up to 91 days. They typically carry low-to-moderate risk and provide high liquidity, making them suitable for investors seeking a relatively stable investment avenue for short-term financial goals. Liquid funds seek to mitigate the impact of market volatility by concentrating on high quality and short duration money market and debt securities. This helps mitigate interest rate risk and credit risk.

How do liquid funds work?

Investment in short-term securities: Liquid funds invest in short-term debt instruments such as commercial papers, certificates of deposits, and treasury bills. These securities typically have maturities of up to 91 days, ensuring that the fund remains highly liquid.

Relative stability: Liquid funds aim to provide reasonable returns potential with low-to-moderate risk.

High liquidity Liquid funds usually allow investors easy access to funds, with some schemes offering instant redemption of up to a certain amount.

Liquid funds seek to generate income through the interest earned on the debt securities in their portfolio. This can potentially result in a relatively steady income stream for investors.

Tax implications on liquid funds

Before the taxation changes implemented in 2023, investors enjoyed specific tax benefits on liquid funds. Capital gains were classified as short-term and long-term, with their respective tax implications. Short-term gains were taxed as per the individual's slab rate, while long-term gains, after the benefit of indexation, were taxed at a concessional rate of 20%.

For liquid fund units acquired before April 1, 2023

Short-term capital gains (STCG): If an investor sells their liquid fund units within three years of the purchase, the gains qualify as short-term. Previously, these gains would be added to the individual's taxable income, thereby getting taxed as per their respective income tax slab. This mechanism for liquid funds taxation remains unchanged for funds acquired before 1st April 2023.

Long-Term Capital Gains (LTCG): Gains arising from selling the liquid fund units after holding them for a period of three years are considered long-term. Before the new rules, these gains came with indexation benefits. Essentially, indexation adjusted the purchase price of the investment for inflation using a government-provided index, reducing the taxable amount. The long-term capital gains would then be taxed at 20% with indexation benefits or 10% without indexation. This rule continues to apply for funds purchased before March 2023.

For liquid fund units acquired after April 1, 2023

With effect from April 1, 2023, the tax on liquid funds has witnessed significant changes. This makes it essential for investors to stay updated and plan their investments in liquid funds accordingly.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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