Take a deep breath. Life has thrown a curveball at you, but you can get through it. Most emergencies will make financial demands on you, and figuring out how best to pay is important. Before you go to your mutual funds, there are two sources of funding that you must first consider:
There is sometimes cash lying at home or in a savings account, which you have totally forgotten about. Alternatively, you may have a sweep-in fixed deposit that allows you to withdraw money at any point in time. Try to locate and gather this money. It is the cheapest and easiest source of funding you have available.
Check your insurance policy
If you have health problems, check your health insurance first. However, some life insurance policies also come with the accident or critical illness features (called ‘riders’). The insurance policy may be something you are paying for or it may be one provided by your employer. You can get information on the latter from your employer or HR manager.
Now, let us get to your mutual funds.
Borrow rather than redeem
Redemption of mutual funds can force you to pay exit loads and make you liable to pay tax. It can also be forced upon you at just the wrong time, before a significant economic event or market rally. One good alternative to redemption is simply to borrow against your mutual fund units. Most banks will offer an overdraft facility, known as the loan against shares (LAS), against your units, with a margin. For instance, your bank may let you borrow up to 80% of the value of your debt funds and 50% of the value of your equity funds. The bank will charge you an interest rate of 8-9% (this will change, as interest rates change) which in many cases may be less than the returns that your funds generate. The interest is charged on a daily basis and will stop running once you pay back the money. Talk to your relationship manager at your bank and open a LAS account for this.
Liquid funds first
The most accessible funds in your portfolio are liquid funds and ultra short-term funds, in that order. If you have holdings of these, you must liquidate them in preference to any other type of fund. They do not usually have exit charges and the funds will arrive in your bank account within one working day. Some liquid funds have an instant redemption facility which gets you your money within a few minutes or has a linkage with a debit card which will allow you to spend your money immediately.
Debt funds second
As a general principle, redeem your debt funds before you redeem your equity funds. Equity funds yield their best returns over long periods of time and hence they should not be redeemed early if you can help it. Within debt funds, identify funds which have crossed a three-year holding period. Debt funds redeemed after three years will carry a long-term capital gains tax of 20% with indexation. Debt funds redeemed before three years time will carry a short-term capital gains tax as per your income slab. Redemption after three years is also unlikely to have exit loads.
Debt fund redemptions typically will arrive in your bank account within two working days.
Equity funds last
After redeeming your liquid and debt funds, if you still need money, you can redeem your equity funds. If this is done after a one year holding period, you will not have incurred a tax liability. Within a one year holding period, you will have to pay short-term capital gains tax of 15%. If you have any sector or thematic funds, redeem these rather than diversified equity funds. Diversified funds form the core of your portfolio and should be redeemed last.
Equity fund redemptions will arrive in your bank account three working days.
Mutual funds carry exit charges known as ‘exit loads.’ These usually get reduced and eventually disappear as your holding period increases. Given the choice, pick a fund which does not have an exit load.
Mind the FIFO
Mutual fund redemptions give rise to capital gains tax which is computed on a first-in-first-out (FIFO) basis. This means that the units bought earlier are considered to be sold first, before newer units. In other words, if you have an old fund with a lot of unrealised gains, it will attract a higher tax liability than a new fund which has few unrealised gains. To reduce this effect, redeem funds with fewer unrealised gains. You will be able to get this information from your fund account statement.
Mutual Funds are a highly effective and convenient method of funding your emergency needs. Make sure that your bank account details registered with the fund are up-to-date and you have opted for electronic credit of funds. Waiting for the arrival of cheques is an unnecessary inconvenience. Emergencies in life should be few and far in between, but it is best to be prepared.