Tax on Liquid Funds: Benefits & Tax Treatment

Tax on liquid funds is a critical aspect that investors must understand to stay compliant with income tax laws. Liquid funds, known for their high liquidity and low-risk nature, offer a convenient option for short-term investments. It is ideal for individuals with short-term financial goals or those looking for better returns than savings accounts. However, the capital gains and dividends derived from these funds are subject to specific tax treatments based on factors like holding period and income source. This article provides a comprehensive overview of liquid fund taxation to help investors make informed financial decisions.

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What are Liquid Funds?

Liquid funds are a type of debt mutual fund that primarily invests in short-term, fixed-income instruments like commercial paper, government securities, treasury bills, and certificates of deposit, with maturities of up to 91 days. These funds offer low risk and high liquidity, making them ideal for investors looking for quick access to their capital. The net asset value (NAV) of liquid funds is calculated daily, and investors can typically withdraw their investments within 24 hours. With their low interest-rate risk and ability to convert assets into cash rapidly, liquid funds are a popular choice for investors seeking short-term profits for their funds.

Benefits of Investing in Liquid Funds

Below, we have listed the major benefits of investing in liquid funds:

• High Liquidity: Liquid funds offer excellent liquidity, allowing investors to withdraw their money within 24 hours. This makes them ideal for managing short-term cash requirements or emergency funds.
• Low Risk: Since liquid funds invest in short-term instruments with maturities of up to 91 days, they carry minimal interest rates and market risks compared to other types of debt funds.
• Stable Returns: These funds provide relatively stable returns by investing in high-quality fixed-income instruments like treasury bills, certificates of deposit, and commercial paper.
• Better Returns than Savings Accounts: Liquid funds typically offer higher returns than traditional savings accounts, making them an attractive alternative for parking surplus funds.
• Transparency and Safety: Liquid funds invest in high-rated instruments, ensuring safety and transparency in operations. Regular portfolio disclosures help investors monitor their investments effectively.

Who can invest in Liquid Funds?

Here are the types of investors suitable to invest in Liquid funds:

• Investors Seeking Low-Risk Options: Liquid funds are ideal for individuals prioritising safety over high returns and prefer investments with minimal risk exposure.
• Individuals with Short-Term Financial Goals: For those who require quick access to their funds, liquid funds offer high liquidity, making them suitable for meeting short-term or emergency needs.
• Those Looking for Higher Returns than Savings Accounts: Investors aiming for better returns than those offered by traditional savings accounts can benefit from liquid funds, which typically provide a higher yield.
• Investors Looking to Park Funds Temporarily: Liquid funds are a secure option for temporarily parking surplus funds. Whether the amount is large from a bonus, the sale of property, or an inheritance, liquid funds can safeguard the corpus while offering modest returns until a long-term investment decision is made.

Tax Treatment on Liquid Funds

Those who invest in Liquid funds must be aware of the liquid fund taxation to ensure compliance. Capital gains and dividends earned through liquid funds are subject to taxation. In the following, you can understand the tax treatment on liquid funds, 

• Short-Term Capital Gains (STCG): If liquid fund units are sold or redeemed within three years of purchase, the gains are classified as short-term capital gains. These gains are taxed at the investor’s applicable income tax slab rate.
• Long-Term Capital Gains (LTCG): Liquid fund units held more than three years before redemption are considered long-term capital gains. These gains are taxed at a rate of 12.5% without the indexation benefits as per the decision made in the Union Budget 2024.
• TDS on Dividends from Indian Companies: Indian companies distributing dividends must deduct Tax Deducted at Source (TDS) at a rate of 10%, provided the total dividend exceeds ₹5,000 in a financial year.
• Taxation on Dividends from Foreign Companies: Dividends received from foreign companies are taxable in the hands of investors. Investors can choose to pay tax at a flat rate of 20% (plus applicable surcharge and cess) instead of their regular income tax slab rate.

How to Declare Income from Liquid Funds in ITR Form?

Declaring income from liquid funds in your Income Tax Return (ITR) is an essential step for compliance with tax laws. Follow these steps to ensure proper reporting of capital gains and dividend income earned from liquid funds:

• Log In to the Income Tax Portal: Visit the Income Tax Department’s official website and log in using your credentials (ID and password).
• Choose the e-filing Option: Select the ‘e-file’ option from the menu. Then click on ‘Income Tax Returns’ followed by ‘File Income Tax Returns.’
• Select the Appropriate Form: Choose the relevant ITR form based on your income details. Select the status and assessment year, and choose ‘taxable income is more than exemption limit’ as the reason for filing.
• Fill in the Necessary Schedules: On the first page, select ‘General’ and on the next page, select ‘Income Schedule.’ Choose ‘Schedule Capital Gains’ and select the type of capital asset redeemed from the drop-down list.
• Report Capital Gains: Liquid fund income will either be short-term or long-term. To report short-term capital gains (STCG), click ‘Add details’ and enter the total amount received from the sale and the acquisition cost. For long-term capital gains (LTCG), provide details of each scrip separately in Schedule 112A. Click ‘Add’ after entering the details. As for dividend income, it should be reported under the ‘Income from other sources’.
• Review the Schedules: Verify all entries and review Part B TT1 after adding the required information. Click on ‘Preview Return’ to check the final details.
• Validate and File the Return: Complete the remaining fields and click on ‘Proceed to Validation’ under the declaration tab. Once validated, you can submit your ITR. To verify, send a signed ITR-V to the Income Tax Department or file it electronically. You have up to 120 days to complete the verification process.

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Conclusion

Understanding the tax implications of liquid funds is essential for making informed investment decisions and maximising returns. While liquid funds offer high liquidity, low risk, and stable returns, investors must consider the tax treatment of short-term and long-term capital gains and dividends to ensure compliance and optimise their financial strategies. Individuals can effectively leverage liquid funds to meet their short-term financial needs by carefully evaluating their investment goals and tax liabilities.

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FAQs

1. What are Liquid Funds?

Liquid funds are low-risk debt mutual funds investing in short-term, fixed-income instruments. They offer high liquidity, making them suitable for short-term investments.

2. What are the benefits of investing in Liquid Funds? 

Liquid funds provide high liquidity, low risk, and stable returns and typically offer better returns than savings accounts, making them ideal for short-term investments.

3. Who can invest in Liquid Funds? 

Liquid funds are suitable for low-risk investors, individuals with short-term financial goals, those seeking better returns than savings accounts, and people lookng to park funds temporarily.

4. What is the tax treatment for Liquid Fund income? 

The tax treatment depends on whether the gains are short-term (within 3 years) or long-term (over 3 years). Under the Union Budget 2024, short-term gains are taxed at the investor’s income tax slab rate, while long-term gains are taxed at 12.5%.

5. How are Short-Term Capital Gains (STCG) from Liquid Funds taxed? 

Short-term capital gains (STCG) from liquid funds are taxed at the investor’s applicable income tax slab rate if the units are redeemed within three years.

6. How are Long-Term Capital Gains (LTCG) from Liquid Funds taxed? 

Long-term capital gains (LTCG) are taxed at a rate of 12.5% for liquid funds held for more than three years without the benefit of indexation.

7. What is the TDS on dividends from Indian companies? 

Dividends from Indian companies are subject to a TDS of 10% if the total dividend received exceeds ₹5,000 in a financial year.

8. How are dividends from foreign companies taxed? 

Dividends from foreign companies are taxable at a flat rate of 20%, plus applicable surcharge and cess, or at the regular income tax slab rate if preferred.

9. How do I declare income from Liquid Funds in my ITR? 

To declare income, log in to the Income Tax Portal, choose the relevant ITR form, report capital gains in the ‘Schedule Capital Gains’ section, and dividend income under ‘Income from Other Sources.’

10. What is the process of filing ITR for Liquid Fund income? 

After selecting the correct form and schedules, review all entries, validate the return, and file electronically or send a signed ITR-V for verification. You have 120 days to complete the verification.

DINESH P Expert

Updated on: January 28th, 2025