Debt fund & Arbitrage funds to take care of short-term goals

Some of the options that are available are short term FDs, Short term Debt funds and arbitrage funds.

In the case of short-term FDs, there is a tenure for which the FDs need to be invested and any premature withdrawal will attract a penalty in some form. Also, the interest earned on an FD is fully taxed as income, depressing the post-tax returns.

There are better options available. Let us consider Debt MFs.

Debt MFs are liquid and do not have long periods with Exit loads. Hence, they are liquid and can be taken out when needed. This makes it an attractive option.

In Debt funds, for upto 36 months Short-term capital gains apply. The short-term capital gains taxes are however the same as normal income tax rates. However, the short-term capital gains calculation is different and is calculated as the difference between cost and sale prices of the units being cashed out. This becomes truly advantageous when one is trying to take out only the gains instead of cashing out the entire investment. Hence, that can be useful in some situations.

Beyond an investment duration of 36 months, Debt MFs are subject to Long-term capital gains taxation. Here, the indexation benefit can be availed of, which adjusts the cost price for inflation. The difference between the selling price and indexed cost price is the long-term capital gain. The tax applicable on this long-term capital gain is 20%. Effective tax is seen to be in the ballpark of about 5-6%, which is attractive.

Arbitrage funds are the other product we recommend for short-term investments. They are equity products where the fund manager cashes in on the difference between current and future prices of securities. The fund manager does this normally by buying the stock now and selling the same in futures market & pocketing the difference. The return potential is low here.

There is a clear tax advantage that arbitrage funds will enjoy, as they are treated as equity investments. For upto one year, the returns one gets is treated as short-term capital gains. It is taxed at 15%, without indexation and offers a clear tax advantage.

For tenures above 12 months, the returns are treated as long-term capital gain. The tax on long-term capital gains is 10% without indexation.

Hence, Arbitrage funds should mostly do well, when it comes to parking money till the time it is needed for the goals.

But, there is a caveat. Arbitrage funds tend to do well in volatile markets & are good places to park one’s funds in such a market. These are hybrid funds with a certain allocation to debt instruments at every point in time. In a market which is range bound, these funds may not do too well.