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How to balance liquidity and tax efficiency in mutual funds

05 Jan 2023

If risk and returns are two key facets of a mutual fund decision, then the other two critical facets of your mutual fund investing are liquidity and tax efficiency. Liquidity is all about ensuring that you have cash available with you when you require it and in the quantity you require. The principal of liquidity is that it should be available to you without having to do a distress sale and destroying the value of your portfolio. Tax efficiency, is a lot more subtle. Most investments and insurance allocations have tax implications. Some instruments provide tax incentives when investing and you need to make the best of it. Others provide lower taxes on regular income on investments. Similarly certain assets are more tax efficient when it comes to capital gains at the time of redemption. Here are the key considerations when you take this trade-off decision.


There is an inverse relationship between the two..

Normally, tax breaks are available in cases where the investment horizon is longer. For example, when you put money in your savings bank account, the interest is taxed at the peak rate of tax. Similarly, bank FDs are also inefficient with respect to tax efficiency. Take the case of equities! When you hold equities for a period of less than one year it is deemed to be short term gains and taxed at 15% while long term gains on equities are tax free. Even in case of debt, the long term gains on debt funds are taxed at a concessional rate compared to the short term gains. In case of equities, if you are willing to extend your time frame to 3 years then you can invest in ELSS Tax Funds where you get the additional benefit under Section 80C of the Income Tax Act. The crux of the argument is that when you opt for liquidity there is a negative tax implication to it. Smart management is all about getting a proper trade-off between the two.


Understanding liquidity from a financial planning perspective..

One of the most important aspects of financial planning is ensuring that liquidity is available when you want and in the quantum you want without upsetting your value creation. Assume that you have home loan margin of Rs.5 lakh payable at the end of 2 years. Should you create a 2-year SIP of Rs.18,000/month on an equity fund or on a debt fund. You can argue that an equity fund will be tax efficient and your capital gains will be tax free. That will surely improve your effective returns. But 2 years is a short time in equities. It is hard to credibly believe that one can see substantial appreciation in the next 2 years. What happens if you put your money in the equity fund and the value of the fund falls by 20% in the next 2 years? That will leave you with a huge financing gap forcing you to sell some other investments. When your time frame is short (as in this case) always prefer liquidity and put the money in liquid funds or even in a short term debt fund. Anything that risks capital depreciation or illiquidity is not a risk worth taking.


What you need to understand about tax efficiency?

Remember tax efficiency is not just about tax breaks but also about how the income and the eventual capital gains are treated. If you look at it from that perspective, the Mutual fund ELSS schemes meet most of the criteria. The risk is reduced due to their longer lock-in period. The lower need to churn and keep cash also enhances the returns on the ELSS. Post its lock-in, the ELSS is normally very liquid and the money can be realized in less than 2 days. But it really takes the cake on tax efficiency.


Tax efficiency has another perspective to it and that is a futuristic perspective. The Indian tax system is gradually moving from an EEE (Exempt, Exempt, Exempt) system to an EET (Exempt, Exempt, Taxed) system. Investment products like provident funds, pension funds and insurance endowments are current exempt at all 3 levels. However, once the move to EET system is completed, then such investments will be taxed in the year of redemption as treated as income in that year. That could substantially change the tax efficiency and therefore the economics of these investments.
This debate on trade-off between liquidity and tax efficiency lies at the core of financial planning. When you are planning your finances over the next 25-30 years, the tax efficiency makes a huge difference.

However, not all your needs are likely to mature after 25 years. You may have to pay your home loan margin after 3 years, your foreign holiday after 5 years, start paying for your child's education after 12 years, and spend for your child's wedding after 18 years and your retirement after 25 years. It is the phased nature of needs that makes the task of balancing your liquidity and your tax efficiency so crucial!

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