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Tax-efficiency in Liquid Funds

I am planning to invest in liquid funds. As short-term gains tax is as high as 30 per cent, how can I withdraw my gains in a tax-efficient manner?

I am planning to invest in liquid funds. As short-term gains tax is as high as 30 per cent, how can I withdraw my gains in a tax-efficient manner?
—Hrishta Sen

You are right. If you redeem your units, it would prove painful because your profits will be clubbed together with your other income and you will be taxed at the marginal rate, which could be as high as 30 per cent.

But there is a way out. You can opt for the dividend option, which is the most tax efficient method of receiving returns from a liquid fund.

The only tax you pay here will be the dividend distribution tax of 12.58 per cent. Within the dividend option, most funds have the option of daily or weekly dividends. Most of the gains are paid out through these dividends. In the dividend option, the NAV rises and then falls once the dividend is paid out. As the frequency of dividend payout is high, the NAV movement looks like a saw tooth. So, the NAV moves within a narrow band close to the face value of the fund unit.

If you are in the weekly dividend option and you redeem before the dividend payout, then the gains left in the fund will be subject to capital gains tax at the marginal rate.

But then one should not worry on this aspect as the competing options such as the interest on short-term bank deposits is also taxed at the same rate. Compared to bank deposits, you will still be better off in a liquid fund where most of your returns are subject to a distribution tax of only 12 per cent.

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