A liquid fund is a debt mutual fund that invests in very short-term instruments — commercial papers, treasury bills, certificates of deposit, and so on. Liquid funds generally invest in instruments that have a very high credit rating.

In fact, liquid funds park your money in instruments not too different from the way banks do and hence are reasonably secure. Though liquid cannot promise a fixed return, their performance over the last 10 years has always been superior to the returns offered by Savings bank. On average liquid funds generate 8-9% returns which are significantly higher than the average savings bank rate of 4%.

Corporate houses have been using liquid funds to park their surpluses and derive some returns. These funds being low risk considering that their exposure to mark to market instruments is limited to the extent of 10%, retail investors can also significantly benefit from these investments.

Liquid fund, just like any other mutual fund have growth and dividend options. While these funds don't charge you on exit, one could potentially utilize the liquid funds to park money and then systematically invest in other high yield schemes. These funds have short tenures, no lock in period and held to maturity by the fund. With the maturity varying anywhere between 4 days to 90 days and redemption within 24 hours, you could temporarily park your surplus in a liquid fund that you might want to redeem shortly to meet a nearing obligation and still enjoy the benefit of a higher return.

With the deregulation of savings bank interest rates by RBI, some banks offer interest rates as high as 7%. Further, the budget took away most of the benefits that debt funds in general offered until last year. Earlier, all capital gains made on debt funds held for more than one year were treated as 'long-term' and taxed at a flat 10 per cent. But now, the tenure for claiming long-term capital gains tax on debt funds has been increased to three years. The tax rate on such long-term gains has also been hiked to 20 per cent (with indexation benefits) instead of a flat 10 per cent. However this change does not affect the liquid funds much which are anyway suited to much shorter investment horizons much lesser than a year.

In any case, the post-tax returns liquid fund still beat the performance of Savings bank.

Under the growth option of liquid funds, the investor is charged as per holding period. If the investor holds the funds for less than 3 years, then he/she is charged short term capital gains as per the tax slab he falls into.

Under the dividend option, the mutual fund company is charged with a dividend distribution tax of 28.84%.

Let's understand this with the help of a small example for some- one who falls in the 20% tax bracket and holds it for a year

Investors have a number of liquid funds to choose from. From a performance point of view, one cannot see much of differentiation between them. However, Crisil Liquid fund index serves as a good yardstick to compare their performance. So the next time you have a pile of cash, don't let it idle in a savings bank account. Learn to manage it better through a liquid fund.