Investing a part of your emergency fund in debt funds can help you maximise your earnings while minimising your tax liability. The emergency corpus should ideally be divided into three levels.
The first layer of emergency funds should be kept in cash in a closet locker. Depending on your unique circumstances, a moderate quantity should enough. The second layer might be a liquid bank account or a fixed deposit. A liquid fund or an ultra-short duration fund can be used as the third tier. It will assist in maximising profits on idle funds while also being tax-efficient.
Unlike fixed deposits, debt fund profits are taxed only when they are realised, which is when you withdraw your money. The interest earned on a fixed deposit is added to taxable income each year and taxed according to the appropriate slab.
The interest on a fixed deposit is therefore taxed at 30% for someone in the highest tax bracket. If a debt fund is sold after three years, the profits are taxed at 20% after indexation is applied. If sold within three years, however, they receive the same tax status as fixed deposits. They can, however, provide larger yields than a fixed deposit.
Keep in mind, however, that unlike fixed deposits, debt funds do not guarantee returns or capital preservation. Liquid funds and ultra-short duration funds are less risky than other debt fund categories, although they still include risk. When choosing a debt fund, don't be misled by bigger returns because they may be taking on more risk. Find a fund that has high-quality papers.
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