Advantages of Money Market Funds and how tax is applied to it

The world of mutual funds is wide and varied. There is something for everyone. The risk-loving investor can opt for equity funds while debt funds fit the bill for the safe investors. Basis SEBI’s re-classification exercise, there are 16 types of debt funds. This classification is primarily basis factors such as the type of debt instrument each fund is permitted to invest in, the maturity period of the underlying instruments or their credit rating. In this article, we will give you an overview of money market funds and why you should consider investing in them.

What are Money Market Funds?

Money Market Mutual Funds providers invest in money market instruments with a maturity tenure of up to one year. For example, 

  • Treasury Bills (T-Bills), 
  • Commercial Paper, 
  • Certificate of Deposits (CDs), 
  • Re-purchase agreements, 
  • banker’s acceptances, etc. 

These instruments are generally highly liquid and ultra-safe. The core objective of Money Market Mutual Funds providers is to help investors with a safe and easily accessible investment avenue for short-term investments. These funds are as safe as putting money in a bank’s saving account, but with the potential of generating higher returns.

Advantages of money market fund investments

  • Liquidity

Money market funds are highly liquid in nature as they predominantly invest in fixed-income securities with a short maturity period. Investors have easy access to their principal investment. This factor makes these schemes suitable for unforeseen or emergency fund requirements. The high liquidity quotient of the market also allows the investors to capitalize on the increasing rate of return (short-term) and accordingly select an appropriate money market fund.

  • Safety

Money market instruments are known as a safe-zone for investors, especially when compared to equity investments. This is due to their high liquidity and the strong creditworthiness of the instrument issuers. Capital preservation is a key objective for Money Market Mutual Funds providers.

  • Returns

These mutual funds have the potential to generate healthy and stable returns, especially when compared to conventional investment avenues such as Bank Fixed Deposits of a comparable time frame. 

Money Market Mutual Funds providers design the funds in such a manner that the fund manager is able to able to adjust the investment duration basis the prevalent market conditions. For instance, when the market rates are on an upswing, these investments earn higher returns in the form of increased interest incomes. In the event of a downtime, they compensate for the reduced interest income through capital gain generation. This also helps to keep the overall risk of the investment under control.

  • Flexibility

These funds offer a great degree of flexibility to investors. They can be issued as well as withdrawn in short duration. 

Taxation of Money Market Mutual Funds

Money market funds are taxed as per the rules applicable to other types of debt funds. The taxation guidelines depend on the holding period of investment.

  • Holding period of fewer than three years

Gains from investment in these funds (when redeemed before completion of three years) are short-term capital gains. These gains are added to your overall taxable income and taxed as per the applicable income tax slab

  • Holding period of more than three years 

Gains from investments held for three years or more are long-term capital gains. The tax rate for such income is 20% with the benefit of indexation. The presence of indexation benefit helps to reduce the tax obligation. The initial cost of investment and the returns earned thereon get adjusted basis the inflationary rates.

The bottom line

Money market funds are the perfect type of debt funds for investors who are looking for a short-term cash-like investment which generates decent returns with minimal risk. These funds can also be a great diversification agent for the overall portfolio.

Published by Nidhi Mehra

I am blogger with 5 years of experience in writing articles and topics related to finance and funds

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