Debt Mutual Fund Taxation - Explained

What is a Liquid Fund, and how does it work?

A Liquid Fund is a Debt Mutual Fund that invests in short-term assets such Treasury bills, repurchase agreements, commercial papers, government securities, and certificates of deposit.  Liquid funds must invest exclusively in debt and money market securities, according to the SEBI. Liquid Funds have a 91-day maturity period and no lock-in period.

Taxation of Liquid Funds

A conventional rule of thumb is that a mutual fund is considered equity-oriented for tax purposes if it invests 65 percent of its assets in stocks. As a result, even Debt Funds that invest a portion of their assets in shares are subject to the same taxation. The remaining assets are placed in fixed maturity plan funds, gold funds, or liquid funds, which are taxed similarly to Debt Funds. Let's take a closer look at the tax consequences of Liquid Mutual Funds alone.

Dividends are subject to taxation.

You can pick between dividend-paying and capital-gain-paying Liquid Funds while investing. If you choose the former, the fund will pay you dividends from its earnings and revenue. Dividends are a type of income that, in theory, compels taxpayers to pay income tax. The Dividend Distribution Tax was repealed by the government in Budget 2020. As a result, dividends generated on Debt or Liquid Funds are tax-free

Capital Gains Tax (CGT)

Liquid Fund is a non-equity investment vehicle. As a result, it is taxed in the same way as a Debt Fund is. Liquid Fund gains are referred to as Short-Term Capital Gains when held for less than three years (STGC). Long-Term Capital Gains apply to Liquid Funds that have been held for longer than three years (LTGC).

LTGC is taxed at 20% for Liquid Funds, and investors can take advantage of the indexation benefit. The term "indexation advantage" refers to the recalculation of the purchase price to account for inflation, hence lowering the tax effect on LTGC in Debt Funds.

The Debt Liquid Fund earnings are added to normal income and taxed according to the investors' income tax slabs for short-term gains. As an investor, if you are in the 30% tax bracket, your maximum tax rate is 30%, but if you are in the 20% bracket, your maximum tax rate is 20%.

If you want to add a short-term investment tool to your portfolio, liquid funds are a great option. Although taxable, Liquid Funds can provide tax benefits if held for prolonged periods of time.