Maximise returns on surplus cash lying in bank accounts

Dividends from arbitrage funds are tax-free for investors because there is no dividend distribution tax on equity funds

OFTEN we keep significant amount of money in our savings bank account. The reasons could be many: meet unforeseen expenses in case of an emergency, lack of time to invest, lack of awareness about safe, liquid, steady accrual generating alternative products. While the first is a valid reasons to keep cash in bank account, the others are not desirable and over a longer period of time there could be a wide difference on a post-tax basis between what you earn by keeping in a bank account and what you could have earned by investing in liquid accrual mutual fund products.

Bank offer anywhere between 4-7% per annum interest rate on cash balance sin a savings bank account. As far as current tax applicability goes, interest earned on savings bank account up to Rs 10,000 can be claimed as a deduction from your gross total income. Over and above that, income is taxable as per applicable tax slab.

To maximize your post tax returns and as an alternative to keeping short term cash surpluses with banks, two types of MF schemes can prove likely alternatives. One is a debt product in the category of ‘liquid’ schemes. By its very nomenclature, the intent is to manage short term surpluses of investors whose investment horizon can be as short as one day and there is generally no exit load. This category has two unique regulatory characteristics: firstly this is the only category of MF Redemptions are usually credited by the next working day. By regulatory mandate this type of fund cannot be invested in debt or money market instruments of greater than 91 days residual maturity. Hence, since these schemes make investments in short-term securities and therefore they are minimally exposed to interest rate fluctuations. By and large the returns area reflection of prevailing short term interest rates and tend to be fairly stable with low volatility.

Currently, most liquid funds have been generating around 8% plus (simple annualized) returns in the last one year. Post RBI rate cut in April 2016 and fall in short term rates, liquid fund returns have declined to be in range of 7.50% - 7.90% on an average. This compares favorably to savings bank account rates. As far as taxation is applicable, liquid funds are subject to capital gains tax as applicable to all categories of debt funds. Short-term capital gains tax (less than three year holding) is taxed for an individual investor as per his applicable tax slab. If one can transact online on the respective MF’s website, the process for investment( debit from savings bank account and invest to liquid fund) and redemption (click to redeem investments online and credit to one’s bank account) becomes fairly simple and seamless.

There is one more category of MF schemes which enjoys an even better tax treatment as compared to liquid schemes and is a moderately low risk, generally steady accrual product. This category is known as arbitrage funds. Arbitrage funds are a category of equity schemes where income is generated through arbitrage opportunities between cash and derivative market and arbitrage opportunities within the derivative segment.

Equity funds do not incur capital gains tax if held for more than one year and, if held for less than a year, short-term capital gains are taxed at 15%. Dividends from arbitrage funds are tax free in the hands of investors because there is no dividend distribution tax on equity funds.