How to optimize returns on your liquid funds?

We all need to maintain liquid balances in our Savings Bank (SB) accounts for various purposes like paying our EMIs, regular living expenditure, cash withdrawals at ATM etc.  Maintaining balance in SB account is inevitable for all of us.    Though there is great convenience in maintaining sufficient liquidity through SB account, it is not a very lucrative proposition from the investor point of view.

The banks normally pay 4% on SB account balance except for few banks like Kotak, Yes Bank and IndusInd, which pays higher interest of 6% to 7%.

In a recent report released by RBI, the amount of deposits held in Savings Bank account across different banks in India is Rs33 lakhs crores.  Yes, you read it right!!  That’s a humongous amount of money to be left in SB account and allowing banks to benefit out of that.

Let’s try to answer ourselves the question of are we maintaining the optimum balance in SB accounts?

It is worthwhile to note couple of things about the Savings Bank account interest.  The first one is low interest rates compared to bank deposits and to rub salt on the wound, you end up paying tax on your SB account interest.

The SB account interest earned above Rs10,000 per annum is taxable.  For example, you have 4 SB accounts and you earn Rs4,000 each as interest during the year, you would have made a total interest of Rs16,000.  Out of this, Rs10,000 is tax exempt and you have to pay tax at your applicable tax rate for the balance Rs6,000.  If you are in the 30% tax slab, you will pay a tax of Rs1,800 and left with only Rs4,200.  Because of this tax impact, the actual yield you make on SB account is much lower than the 4%, we all think we are making.

So, the important question is:  are we maintaining the optimum balance in our SB accounts?  We can decide the optimum balance by drawing up a monthly budget and retain 2 to 3 months expenses in Savings Bank account.  The rest of the money may be held in much more efficient investment avenue which provides similar kind of liquidity but much higher returns.

Liquid Mutual Funds is the answer:

Liquid Mutual Funds collects money from investors and purchases debt instruments like Treasury Bills, Certificates of Deposits and Commercial Papers, which are issued by Government, Banks and Companies.  The maximum maturity allowed for Liquid funds is 90 days.

The Liquid Mutual Funds provide much better tax efficient returns along with decent liquidity (though not exactly comparable to the liquidity of a SB account).

The credit ratings of these liquid mutual funds are very high and there is close to zero risk in these investments.  These debt instruments would earn interest in sync with the prevailing interest rates in the economy.

Returns made by Liquid Mutual Funds:

Description 1 Year Return 3 Years Return 5 Years Return
Highest Return from a Liquid Mutual Fund 9.80% 10.08% 8.77%
Lowest Return from a Liquid Mutual Fund 7.2% 7.11% 5.73%

As you can see above, the lowest return produced by these Liquid Funds are much higher than the returns what you would have got from your Savings Bank account balance.

Operational Convenience:

Across all the mutual funds, there is no entry or exit load in liquid mutual funds.  That is, you can enter and exit any time.  You may even hold investments in liquid funds on an overnight basis.  The redemption from liquid fund is normally processed in 1 working day and your bank account gets credited on T+1 basis.

The beauty of these liquid mutual funds is you can create/set up, purchase and redeem all your transactions on the web.  There are few mutual funds who also provide you with an option to transact through your mobile phone.  One Mutual Fund (Reliance) even offers an ATM card for your convenience.  Convenience is the cornerstone here and all mutual funds are working to make it smooth and hassle-free for the customer.

Taxation:

I know now everybody is keen to know how the returns from liquid funds are taxed.  There are two options which are available to the investors, being, growth option or dividend option.  Under Dividend option, there is a dividend re-investment option as well.

Since they are part of the debt mutual fund category, the gains you make on liquid mutual funds are taxed as Capital Gains and not as interest income, if held for more than 1 year.

The advantage under Capital Gains taxation is the indexation benefit, which in all practical sense helps to bring down the effective tax rate to less than 5%. Compare that with Savings Bank deposit interest, which is taxed at the highest tax slab of yours.  There is a tremendous tax advantage in respect of liquid funds.

If you opt for dividend option, then the Mutual Fund would deduct the Dividend Distribution Tax (DDT) at 25% before they pass on the funds to your account.

So, the ideal option is to park money for longer tenures and enjoy liquidity as and when required along with lower tax rates.  But if you are going to park money for short term (less than a year), then choose the dividend re-investment option.  

If somebody is holding excess average balance of Rs200,000 in his SB account, he/she is losing more than Rs8,000 per annum, without even realising it.

What are you waiting for?

Review your monthly cash flows and move the excess money in to Liquid Mutual Funds and earn higher tax efficient returns.

Key points to note in this article:

  1.  SB account interest above Rs10,000 is taxable
  2. Liquid Funds are better alternatives to maintaining excess liquidity in Savings Bank account
  3. Liquid funds provide tax efficient returns
  4. If you are going to hold the investment in liquid funds for more than a year, then go for the growth option
  5. If the holding period in liquid fund is less than 1 year, it is advisable to go for dividend re-investment option
  6. Liquid Fund transactions can be done conveniently over the internet, phone etc.,