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Using mutual funds as an alternative to a savings account

07 Jul 2023

If you always thought that keeping money in your savings account is the safest and surest way of ensuring liquidity then you need to think again. You will be surprised to know that your liquid funds come very close and can also be like a bank savings account, albeit with some advantages. Let us understand liquid fund vs savings account in greater detail. What the benefits of mutual funds with specific focus on liquid funds? Are there are other alternatives to savings account India, other than liquid funds. Let us look at liquid funds and how they compare with bank savings account on a four different parameters.


How the returns compare

In pure returns terms, liquid mutual funds surely score over bank savings accounts. An average bank savings account pays an interest of 4% per annum and that is where it has stayed for a very long time. This interest is also paid only on the minimum balance that you maintain between the 10th of each month and the last day of the month. And that is the gross return on your bank account. There are charges for bank statements, fund transfers and for not maintaining minimum balance. When you factor all these, the actual return on your savings account is much lower. Liquid funds, on the hand, return an average of 6% to 6.5% on annualized basis after considering all costs. That is a more transparent return. You can enhance your returns by moving to liquid plus funds but even if you don’t that risk, you are still at least 200-250 basis points better off than a bank savings account. Of course, returns on a liquid fund are not assured but as long as the liquid fund invests in short term maturities of less than 90 days, you will get that return.


How the risk compares

Risk wise, one can argue that your savings bank account carries deposit insurance but your liquid funds do not. That is really not very material. Firstly, the deposit insurance is only available to the extent of Rs.1 lakh of deposit and not beyond that. Secondly, liquid funds invest in safe instruments like call money, treasury bills and short term bonds. The risk that we are talking about in case of liquid funds is, therefore, more theoretical than actual. While savings banks are as good as risk free, even your investments in liquid funds are carry almost infinitesimal risk.


How the liquidity compares

Liquidity refers to how quickly one can convert into cash. A savings account is near cash and is probably the most efficient source of liquidity after keeping cash under your pillow. Savings accounts, nowadays, can be accessed round the clock and around the world without any costs. With online transfers enabled and internet banking, you are not too far from your savings account. Technically, a liquid fund is not as liquid as a bank savings account, but things are surely changing. Liquid funds started off with next day redemptions but are now offering same-day funds credit. In fact, most liquid funds now have banking tie-ups to also offer you checking facility on the same day. So if you can really plan your liquid fund redemption with a 24 hour leeway, then your liquid fund can almost be as good as your checking savings account.


How the tax implication compares

It is in terms of tax treatment that liquid funds actually score over the bank savings account. When you earn interest on your savings account, this interest is added to your taxable income and your peak rate of taxation is applicable to interest. So if you are in the 30% tax bracket and earning an annual income of Rs.25 lakhs, then your effective tax rate will be 30.9% (30% tax + 3% cess). Remember, if your taxable income is above Rs.50 lakhs then you also pay 10% surcharge and your effective tax rate will be 33.99% (30% tax + 10% surcharge + 3% cess). Your tax liability will go up proportionately.


The liquid fund is a lot more tax efficient. Ideally, do not opt for dividend plans but opt for growth plans. If you hold the liquid fund for less than 3 years it will be taxed at the peak rate, just like your savings account. But if you hold for more than 3 years, you will be charged at 20% of LTCG with the benefit of indexation. Here is how it works.


ParticularsBank Savings AccountParticularsLiquid Mutual FundAmount DepositedRs.5,00,000Amount DepositedRs.5,00,000Interest Rate4% per annumAnnual CAGR return6%Interest in 3 yearsRs.60,000Investment Value after 3 yearsRs.5,95,508Tax at 30.9%Rs.18,540Return in 3 yearsRs.95,508Post Tax IncomeRs.41,460Indexed Cost of Acquisition (272/240)Rs.5,66,667

Taxable capital gainsRs.28,841

20% tax on LTCGRs.5,768

Post Tax IncomeRs.89,830

The effective post-tax return that the investor earns from the liquid fund is more than double what he would earn from a bank savings account. Apart from the higher rate of return, the more favourable treatment of liquid funds also enhances effective returns.

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