A Comprehensive Guide to Liquid Funds

Not every investment you make needs to be locked up for years or come with high risks. Sometimes, you just need a place to park your money for a short while. That, too, without letting it stay idle. And that’s what liquid funds do for you.

Liquid funds are a low-risk, short-term investment plan. They provide better returns than a regular savings account and quick access to your money. But how exactly do they work? And are they right for you? Here’s everything you need to know about them.

Understanding Liquid Funds

In very simple words, liquid funds are a category of debt mutual funds. They invest primarily in short-term money market instruments. These instruments include certificates of deposit, treasury bills, commercial paper, and other debt securities with short-term maturity.

The main objective of liquid funds is to provide high liquidity and reasonable returns with minimal risk.

For example, you receive a bonus or have idle cash in your bank account. Then, you can easily invest it in a liquid fund. This allows your money to earn better returns than a standard savings account. And you can still access it when you need it.

Why Choose Liquid Funds?

Short Maturity Period

Liquid funds invest in securities that have a maturity of less than 91 days. This short tenure helps reduce interest rate risk. Additionally, it ensures your funds remain accessible.

High Liquidity

You can redeem your investment in a liquid fund at any time.  The money is often received in your bank account within one working day. This makes liquid funds suitable for emergency funds or temporary parking of surplus cash.

Stable Returns

Returns from liquid funds are generally stable and less volatile compared to equity or long-term debt funds. According to The Economic Times, liquid funds have provided average annual returns of approximately 7.03% over the past year.

Low Risk

Since liquid funds invest in high-quality, short-term instruments, the risk of default or loss is relatively low. However, as with any investment, some risk remains.

No Entry or Exit Load

Most liquid funds have no lock-in period, making them a cost-effective option for investing or withdrawing at your convenience.

Who Should Invest in Liquid Funds?

Liquid funds are ideal for:

• Salaried Individuals: If you receive a lump sum (like a bonus) and want to earn extra returns before using it, liquid funds are a smart choice.
• Business Owners: Use liquid funds to manage business cash flows. They ensure idle funds work harder for you.
• Retirees: If you want to keep your emergency fund accessible but earn more than a bank account, consider liquid funds.
• New Investors: If you're new to mutual funds and looking for a low-risk option, liquid funds offer a gentle introduction.

Key Advantages of Liquid Funds

Better Returns

Liquid funds typically offer higher returns than traditional savings accounts.

Low Expense Ratio

These funds typically have a low expense ratio. This means a higher portion of the returns stays with you.

Low Volatility

Because they invest in short-term, high-quality instruments, liquid funds are less affected by market fluctuations.

No Lock-in Period

Unlike fixed deposits or other tax-saving investments, liquid funds do not have a lock-in period. You can withdraw your money whenever you need it.

Diversification

Liquid funds invest in a mix of instruments, reducing the impact of any single security that underperforms.

Disadvantages of Liquid Funds

Liquid funds are considered low-risk. But it’s important to be aware of potential risks. This includes:

Credit Risk

It’s rare, but a security issuer might fail to repay. Choosing funds managed by experienced professionals can help reduce this risk.

Interest Rate Risk

It is minimal. Liquid funds are less sensitive to interest rate changes than other debt funds, but sharp movements in rates can still impact returns.

Not Completely Risk-Free

Unlike tax-free investments such as PPF, liquid funds are not guaranteed by the government. There is always a small risk associated with market-based instruments.

No Fixed Returns

Unlike fixed deposits, returns from liquid funds can fluctuate based on prevailing interest rates.

Note: Always review the fund’s portfolio. Go with AMCs that invest in AAA-rated or government-backed securities.

Taxation of Liquid Funds: What You Need to Know

Short-Term Capital Gains (STCG)

If you redeem your liquid fund units within three years, the profits are taxed as per your income tax slab. 

Long-Term Capital Gains (LTCG)

If you hold your investment for more than three years, the gains are taxed at 20% with indexation benefits. Indexation helps reduce your tax liability by adjusting the purchase price for inflation.

Tax on Income Distribution (IDCW Option)

Suppose you opt for the Income Distribution cum Capital Withdrawal (IDCW) option, which is commonly known as dividends. In that case, the amount distributed is added to your taxable income and taxed as per your slab.

 If the total dividend exceeds ₹5,000 in a financial year, a 10% TDS is deducted.

Final Thoughts

Liquid funds are not about chasing high returns. They’re about smart money management! They are a reliable option for Indian investors seeking safety, liquidity, and better returns than a savings account.

Whether you're experienced or a beginner, understanding liquid funds can help you make smarter choices for your short-term investment plan. Always compare your options, consider your risk-taking ability, and consult a financial advisor if needed before investing.