Liquid Funds Vs FD: Which is a better option from taxation perspective?

New tax rules in India can make liquid funds with higher returns beat fixed deposits despite higher tax rates, consider your situation before investing.

Looking for a low-risk investment option to park your savings?  Both liquid funds and fixed deposits are popular choices for risk-averse investors. But which one is right for you?  This article breaks down the key differences to help you decide.

Liquid funds and fixed deposits (FDs) offer a safe haven for your money, but with some key distinctions:

Liquid Funds: These invest in short-term, low-risk instruments like treasury bills and commercial paper. They offer slightly higher returns than savings accounts and are ideal for short-term goals or parking surplus cash.

Fixed Deposits: Offered by banks and some financial institutions, FDs lock your money for a fixed period in exchange for a guaranteed interest rate. They are a good option for long-term goals and income generation.

Who Should Invest in Liquid Funds?

Risk-Averse Investors: Liquid funds are a good fit for those seeking low-risk investment options.

Short-Term Goals: Need easy access to your money? Liquid funds are highly liquid, allowing for quick withdrawals.

Higher Returns Than Savings Accounts: Liquid funds offer better returns than traditional savings accounts.

Who Should Invest in Fixed Deposits?

• Long-Term Goals: FDs are ideal for long-term financial planning, like retirement savings.
• Guaranteed Returns: FDs offer a fixed interest rate, providing predictable returns.
• Low Risk: Since FDs are typically backed by banks, they are considered a low-risk investment.

Taxation: 

If you invest in a liquid fund, you'll be subject to short-term capital gains tax if you redeem your investment within three years. This means the gains will be taxed at your regular income tax slab rate.

Liquid Funds (Short-term):

• Taxed like regular income: Gains from liquid funds held for less than 3 years are taxed at your income tax slab rate. So, if you're in the 30% bracket, your returns are taxed at 30%.
• No special tax benefits: Unlike equity-oriented mutual funds, which benefit from a concessional tax rate of 15% on STCG, liquid funds, being debt-oriented, are taxed as per the individual’s income tax slab with no special tax advantage.

Fixed Deposits (FDs):

• Taxed like regular income: Similar to liquid funds, the interest earned on FDs is taxed at your income tax slab rate.
• Tax deducted at source (TDS): Banks may deduct a small tax (TDS) upfront if the interest earned in a year exceeds Rs 40,000 (Rs 50,000 for senior citizens).
• Tax exemptions for seniors: Senior citizens can claim an exemption on FD interest income up to Rs 50,000.

"As per Section 194A of the Income Tax Act, if the interest earned from an FD exceeds Rs 40,000 in a financial year (₹50,000 for senior citizens), Tax Deducted at Source (TDS) at the rate of 10% is applicable. However, if the individual does not furnish their Permanent Account Number (PAN) to the bank, TDS is deducted at 20%. Additionally, the provisions of Section 80TTB provide senior citizens an exemption of up to Rs 50,000 on interest income from FDs,"said Amay Jain, Senior Associate, Victoriam Legalis - Advocates & Solicitors.

The New Tax Option:

Reduced tax rates, but no exemptions: The Finance Act 2020 introduced a new tax regime with lower tax rates. However, you can't claim exemptions or deductions like the senior citizen benefit on FD interest under this regime.
 

Post-tax returns matter: Let's say you're in the 20% tax bracket. A liquid fund offering 6% returns might be better than an FD with 5% returns, even though liquid fund gains are taxed higher. This is because after considering taxes, the liquid fund might give you a higher return (4.8% vs 4%).

"Taxpayers opting for the new regime will still pay tax on STCG from liquid funds at the applicable slab rates and interest from FDs will be taxed as income from other sources. For instance, an investor in the 20% tax bracket may prefer a liquid fund offering 6% returns over an FD offering 5% returns because the post-tax return from the liquid fund (4.8%) could be higher than the post-tax return from the FD (4%), despite the higher tax rate on liquid fund gains. Tax efficiency plays a crucial role in investment decisions, and understanding these provisions helps in optimizing post-tax returns. Thus, the choice between liquid funds and FDs should be based on one’s tax slab, investment horizon, and liquidity needs, ensuring compliance with the tax laws while maximizing returns,"said Jain.

Choosing the Right Option:

Need your money soon & want potentially higher returns? Consider liquid funds, even though taxes might be a bit higher.
 

Planning for the long term & prefer guaranteed returns? Fixed deposits might be a better choice, especially if you're a senior citizen eligible for tax breaks under the old tax regime.