One of the aspects of achieving financial efficiency is being prepared for unforeseen debt situations. You could lose your job or there could a medical emergency; either way, it is ideal to have at least two to three months worth of living expenses saved away to meets these needs.
Further, since these are meant to meet emergency needs, the money cannot be locked away in an investment or asset but has to be kept in liquid form for quick access.
The first thought of liquidity is always associated with a savings account. However, with an interest rate of as little as 3 to 4 percent offered on them, it may not be ideal to keep a large sum aside earning very little.
How much should you set aside in your emergency fund?
As mentioned before, experts suggest that 2 to 3 months' worth of expenses should be maintained as emergency fund. These expenses should include your loan EMIs, regular payments towards utilities, child's school fees, etc so as to avoid penalties on these and also to not cause disruptions in the lives of your family.
The extent of these savings will vary from person to person based on their monthly earnings, number of dependents and debt obligations.
Deciding between savings account and liquid funds
Savings bank accounts come with low interest earning capacity which are taxable as well. These are risk-free forms of investments and can be accessed at any given time using internet banking options.
Assuming that ideally, you will not need the complete 2 to 3 months of expenses saved at once, you can choose to keep only a part of the emergency fund in a savings bank account and the rest in a safe instrument that earns higher interest rate. This leaves you will two other options, a fixed deposit account or liquid funds.
What are liquid funds?
Also known as debt funds, these are mutual funds that mainly invest in fixed income (interest) instruments like corporate bonds, government securities, treasury bills and commercial papers. These are considered minimum risk instruments when compared to equities.
Short-term debt funds could range from 3 months to 1 year, while medium-term funds could be held for 3 to 5 years.
Unlike a fixed deposit, the interest to be earned on a liquid fund is not known in advanced or guaranteed. They involve some extent of risk, which also makes them capable to giving returns higher than a secure bank FD.
When held for a longer period (say 3 years) and with a reliable mutual fund manager, debt funds have known to beat FD returns.
Further, if you decide to withdraw an FD before it matures, you will have to pay penalties and withdraw the whole amount at once.
Debt funds, which are also credited within 1 to 2 days of withdrawal, just like an FD, do not come with penalties on premature withdrawal. You do not need to withdraw the whole amount either, you can choose to take money to the extent of your requirement.
Taxes are applicable on earnings made on savings deposit, fixed deposit as well as debt funds. FD and saving account interests are taxed at source, which means these are treated as normal earnings and the tax on interest earned is deducted by the bank before it is credited to your account.
Liquid funds or debt funds are taxed based on their term. Funds held for less than 3 years are taxed as short term capital gains (STCG) at 20 percent after indexation. Those held for 3 or more years are taxed as long-term capital gains (LTCG) that are also taxed as per the individual's tax slab.