Radha and Sheela met with an accident on the way to work.
Although there was no hospitalization required, the friends spent close to Rs 30,000 each, on various expenses.
While Radha dipped into her savings account to pay for these expenses, Sheela sold some of her liquid funds for this amount. Both the women had withdrawn from their liquid pool of funds to meet this unexpected expense.
But which one is the better option? Does it make sense for an individual to look beyond the traditional savings account to meet emergency expenses?
There are different options today to park short term funds which can be liquidated easily.
Savings account is the most popular option which has also traditionally been the choice for majority of people. However, any interest earned on a savings account which exceeds Rs. 10,000 in a year is taxable at the income tax slab of the investor.
There are other avenues which yield better post tax returns when compared to savings accounts.
Here are some such options:
Liquid funds:
Liquid funds are open ended mutual funds of the debt category which invest in liquid instruments, such as money market instruments. There is no exit load on such instruments and therefore, no lock in requirements. As the money is invested in instruments with a very short term, the volatility and risk of interest rate movements is very low.
In the Budget for 2014, the taxation rules for debt mutual funds were changed. Accordingly, the investment period for being considered a long term asset was increased from 12 months to 36 months. Short term capital gains are taxed as per the income tax slab of the investor and long term capital gains are taxed at 20% after indexation. For dividend schemes, the dividend distribution tax is 25% plus surcharge and cess.
Although tax rules have become more stringent for liquid funds, liquid funds can yield a higher income compared to savings accounts. This is because most banks continue to offer only 4% interest rate on their savings account.
Additional read: How to invest in MF when your time horizon is less than 5 years
Short term deposits:
Fixed deposits and recurring deposits with banks are other avenues for parking funds on a short term basis. Although the interest rate offered is higher than savings bank accounts, deposits with short duration have lower returns compared to liquid funds.
Short term deposit durations with banks start from as low as 7 days. It is recommended to balance the interest rates offered with the liquidity requirements. This is because premature withdrawal of deposits usually attracts a penalty which is reduced from the interest earned.
Therefore, although bank deposits can be liquidated easily, you may be charged a penalty if the withdrawal takes place before the maturity date. Interest on deposits is subject to tax at the income tax slabs applicable to the investor.
Gold ETFs:
Gold ETFs are vehicles which allow investors to diversify their asset base by investing in gold. These are open ended mutual funds which invest in gold, with each unit representing 1 gram of gold.
They are liquid, carry no risk of holding physical gold and can be easily bought and sold through a demat account. For taxation purposes, gold ETFs held for less than a year are categorized as short term capital assets and are taxed at income tax slabs of the investor. Long term capital gains are taxed at 20% with indexation. Returns on gold ETFs mirror gold price movements and are therefore, not risk free.
Indians invest in gold in different ways.
Short term mutual funds:
You can invest in mutual funds for the short term. However, equity mutual funds are best suited for the long term due to market volatilities in the short term. There are different categories of debt mutual funds which are suitable for the short term. These include income funds, bond funds, ultra short term funds etc.
These debt mutual funds invest in debt instruments and can be liquidated at short notice. The returns of these funds are usually higher than that of savings account interest. Taxability is similar to those of liquid funds. However, these carry interest rate risk and volatile interest rates can be risky for the returns of this option.
Savings cum deposit accounts:
Popularly known as sweep accounts, these are essentially savings bank accounts which carry a minimum threshold amount. Any balance in the account which is in excess of the threshold amount will automatically be moved to a fixed deposit account. This deposit will operate on similar terms as a normal fixed deposit.
This type of account ensures that there is no idle cash in the savings account. However premature withdrawal from the deposit account will attract penalty.
Savings account is popular, easy to opt for and carries low risk. However, the tax returns you get from your short term funds parked in a savings account can be much lower than the above options. It may be worthwhile to evaluate these other options after considering your risk profile.