Taxation on Liquid Funds in India

Understanding the tax implications is crucial for making informed decisions and maximising returns in the dynamic landscape of financial markets. One such essential investment option in India is liquid funds. This article aims to explain the taxability of liquid funds in India, providing investors with essential insights into the taxation framework governing these investment instruments. 

What are Liquid Funds?

Liquid funds are a debt mutual fund that prioritises two things: easy access to your cash and predictable returns. They achieve this by investing in short-term debt instruments, typically maturing within 91 days. These instruments include money market options like treasury bills, commercial paper, and certificates of deposit. 

The return of a liquid fund depends on the market price of the securities held by the fund. While short-term securities typically experience less fluctuation compared to long-term bonds, liquid funds offer relatively stable returns compared to other debt funds.

Tax on Liquid Funds

Liquid funds offer high liquidity and the potential for steady returns, making them a popular choice for investors. The Budget 2023 introduced key amendments affecting the taxation of Specified Mutual Funds. Starting from 1st April 2023, any gains from the transfer of units of these funds will be classified as short-term capital gains, regardless of the holding period. As a result, debt mutual funds will now be taxed according to individual income tax slab rates.

Additionally, indexation benefits will no longer apply, as such funds will no longer be considered long-term capital assets.

However, for investments made before 1st April 2023, the provisions of long-term capital gains still apply. To qualify as a long-term asset, the units must have been held for over 24 months from the date of acquisition. In this case, the gains will be taxed at 12.5%, and indexation will not be available.

Taxation Of Debt Mutual Funds After 1 April 2023:

Gains are taxed at applicable slab rates irrespective of the holding period.

Taxation Of Debt Mutual Funds Before 1 April 2023

Earlier, the taxation of debt mutual funds was governed by the holding period rule:

• Short-Term Capital Gains: If the debt mutual fund unit is sold within 36 months (three years) of purchase, the gains are termed short-term capital gains (STCG). These STCGs were taxed at slab rates.  
• Long-Term Capital Gain: However, if they were sold after 36 months, then the gains were termed long-term capital gains (LTCG). These long-term capital gains were taxed at 20% with an indexation benefit. Indexation benefit means the gains made by investors were adjusted for inflation. 

Dividends:

Dividends received on liquid funds (mutual funds) are taxed at the income tax slab rate applicable to the assessee. Tax deducted at source (TDS) at 10% is applicable to dividends received in excess of Rs 10,000 from FY 2025-26 (Rs. 5,000 before 1st April 2025).

Example for taxation on liquid fund 

Scenario 1: Short-Term Capital Gains (STCG)

• You invest Rs. 10,000 in a liquid fund on January 1, 2024.
• On April 1, 2024 you redeem your investment and receive Rs. 12,000 (Rs. 10,000 principal + Rs. 2,000 gain).

Tax Calculation:

• Your short-term capital gain is Rs. 2,000 (Rs. 12,000 redemption - Rs. 10,000 investment).
• Since it's an STCG, this gain is added to your total income and taxed according to your income tax slab rate.
• Let's assume you fall under the 30% tax bracket.
• Tax liability = Rs. 2,000 (gain) * 30% (tax rate) = Rs. 600.

Scenario 2: Long-Term Capital Gains (LTCG)

• Consider an investment of Rs. 50,000 made in a liquid fund on March 1, 2020 (before April 1, 2023).
• On August 1, 2024, you redeem your investment and receive Rs. 65,000 (Rs. 50,000 principal + Rs. 15,000 gain).

Tax Calculation: 

• Long-Term Capital Gain = Rs. 65,000 (redemption) - Rs. 50,000 = Rs. 10,000.
• Tax liability = Rs. 10,000 (LTCG) * 12.5% (tax rate) = Rs. 1,250.

Related Articles

Best Liquid Funds
Debt Funds