Most of the financial experts advise people to create a contingency fund to deal with financial emergencies like job loss, illness or business loss. The fund should be sufficient enough to cover the expenses for the minimum six months.
For many people, contingency fund means keeping cash in a bank saving account. However, the interests earned on these savings accounts rarely go above 4%. Even those banks which offer high-interest rates on savings accounts, ask for a higher minimum deposit.
Still, many people prefer to park a significant amount of their cash in these low-yielding savings accounts, which means, they earn returns lower than the inflation rate. So, while the purpose of creating a contingency fund is to tide over unexpected money crisis, is saving account the only way to build the emergency fund? The answer is No.
While, it is necessary to have a contingency fund, what is more important is that it should be sufficient to meet any unexpected needs. It is essential to find an investment option which gives returns higher than a savings account and comes with good liquidity attribute as well. Here, liquid funds come into the picture.
What Is Liquid Fund?
Liquid funds belong to that class of mutual funds which primarily invests in money market instruments, like treasury bills, certificate of deposits, term deposits and commercial papers. As these liquid funds come with a low maturity period, it helps investors to meet their unanticipated expenses. The best liquid funds not only give safety, but they also help you fetch high-interest rates than bank savings accounts.
Why Should You opt for Liquid Funds?
The answer to the question is simple and straight— to earn high returns. Over the past few years, liquid funds have given returns, over 8% on an annualised basis. Undoubtedly, this is higher than what you can get on your bank saving account.
By investing your money in the best liquid funds, an investor can enjoy ample benefits. Here are some advantages of liquid funds:
- Liquid funds have no lock-in period, and thus, you can withdraw money whenever there is a need
- On business days, the request for withdrawing money from liquid funds is usually processed within 24 hours, which means easy access to money
- Among other debt funds, liquid funds come with the lowest interest rate risk as they primarily invest in securities with short maturity
- Liquid funds come without entry and exit loads
How Are Liquid Funds Taxed?
Dividends earned under liquid funds are not taxed at the hands of the individual investors, but fund houses pay distribution tax. Those investors who earn profits on their liquid funds within the first year of the investment, have to pay tax as per their income tax slabs. If the liquid fund investor redeems the liquid fund units after the year, they would have to pay a long-term capital gain tax. If we talk about the bank saving account, you would have to pay tax on the interest earned from saving deposits, if it exceeds Rs 10,000.
Usually, idle cash is parked in the liquid funds for a short duration. Hence, investors can go with the dividend reinvestment option to ensure their money stay invested. In other cases, the dividends will be electronically credited to an investor’s bank account.
How to Choose the Best Liquid Fund?
As liquid funds make a significant investment in the underlying securities, the returns are unlikely to vary. However, while choosing the liquid funds, don’t consider the past returns only. There are other factors like the track record of the fund house, fund size, etc.; which should be considered in order to find the best liquid fund.
Though there is a little risk associated with liquid funds; it is a better option than a savings account because of no lock-in period and the high returns. Most often, people avoid investing in mutual funds due to limited market knowledge. However, by investing in a liquid fund, one gets an opportunity to understand the working of mutual fund investments along with the ease associated with them at the time of redemption.