Ram has cash surplus of 100000 which is idle in savings bank account earning interest of 4% and he wanted to use for his vacation goal after 4-5months.He had lost opportunity cost of 4-5% investing in bank savings account and also not able to earn inflation adjusted return.
Here comes smart decision of investing in liquid mutual funds. As the name suggests these funds have high liquidity and less volatile returns. These funds invests in money market instruments like certificate of deposits, Term Deposits, Treasury bills and commercial paper of tenure less than 91days. Most of these money market instruments are issued by Govt. backed institutions(PSU Banks) , so the risk of default is negligible. More over the average maturity of these instruments are so low , they are less likely to be affected by interest rates fluctuations.
Liquid funds pre tax returns are typically in 8-9% range compared to saving account which is 4%.In terms of liquidity they do not have any exit loads and can redeemed at any point of time, usually the proceeds will be credited in 2 Business days to your bank account.
As these instruments has low default risks they are High credit rated securities and hence low risk.
Since investors prefer Liquid Funds for short-term, say a day to few months, capital gains tax is levied as per tax slab rate. However, the interest earned on saving bank account is also taxed as per your tax slab. If you redeem liquid funds after 3 years, they have to pay a long-term capital gains tax of 20 per cent with indexation benefit. This helps for higher tax slabs. Historically effective tax rate for liquid funds are about 1-2% only after indexation.
Nowadays, some funds has ATM withdrawal of cash and SMS facility for redemption request which add convenience to the client.
On the whole before investing in liquid funds Initially Set your priorities if you need cash for daily operations keep one month of committed expenses in savings bank and shift rest of the surplus in liquid fund for your short term goal.