Debt funds after the tax change: where to park cash

What changed, and what it means now

Until March 2023, debt mutual funds had a tax edge over fixed deposits. Hold one for more than three years and the gain was taxed as long-term, at 20% after indexation, which often brought the effective rate close to nothing.

That edge is gone. For units bought on or after 1 April 2023, a fund that holds more than 65% in debt and money-market instruments (a "specified mutual fund") has every gain added to your income and taxed at your slab rate, whatever the holding period. There is no indexation and no long-term rate. Older units, bought before that date and held for more than 24 months, are taxed at 12.5% without indexation.

This is the same treatment as FD interest, with two differences that still matter: tax on a fund is due only when you redeem, not every year as interest accrues, and no TDS is deducted on capital gains for a resident investor. The full rules, including hybrid and international funds, are in our guide to mutual fund taxation.

So the question for short-term money is no longer "debt fund or FD for the tax break". It is: which option gives the return, liquidity and stability you need, after the tax that now applies?

What the short-term categories returned

Median returns of Direct Growth plans, computed from daily NAVs to 1 October 2026 (liquid and overnight funds publish NAVs a few days ahead, so theirs run to 4 October). Volatility is annualised over three years, and "worst fall" is the median of each fund's largest decline over three years.

Three points from the table:

• Over one year, liquid, money market, ultra short and arbitrage funds landed within about 0.15 points of each other, around 6.5%. Overnight funds, which lend only for one day, returned about 1.2 points less.
• Short-duration funds had the weakest year and the bumpiest ride of the debt categories. They hold bonds of one to three years, so their prices move when interest rates do. Their three-year median is as good as any, but over three months they returned 0.66% while liquid funds returned 1.54%. That is the risk of using a longer-duration fund for money you need soon.
• Arbitrage funds are the most volatile line in the table, about six times a liquid fund's volatility, because their returns come from the gap between cash and futures prices, which widens and narrows with the market. Even so, their median worst fall over three years was under half a per cent.

The comparison that matters: after tax

Arbitrage funds hedge their stock positions completely, so they carry little market risk, but they keep at least 65% in domestic equity and are taxed as equity funds: 20% on gains from units held up to 12 months, and 12.5% above ₹1.25 lakh a year on units held longer. Debt funds are taxed at slab. The arbitrage funds guide explains how they earn their return.

Take ₹5 lakh parked for a year at last year's median returns, with 4% cess and no surcharge:

In the 30% slab, the arbitrage fund kept about ₹3,900 more. In the 20% slab, the two were about ₹500 apart, and the liquid fund got there with a sixth of the volatility. Below 20%, the liquid fund wins outright. Hold the arbitrage fund past 12 months and its gain becomes long-term, taxed at 12.5% and only above the ₹1.25 lakh yearly exemption, which widens its lead for a high-slab investor.

These are one year's returns. The gap between the two categories changes with market conditions and can turn the other way, so treat the table as a method, not a forecast.

Matching the parking spot to the time you have

Days to a few weeks, or an emergency fund. A savings account, an overnight fund or a liquid fund. Liquid funds offer instant redemption of up to ₹50,000 a day at many fund houses and the full amount by the next working day. A small exit load applies to liquid fund units redeemed within the first seven days. See overnight vs liquid vs ultra-short funds.

Three months to a year. Liquid, money market or ultra-short funds for a low-slab investor; arbitrage funds become worth the extra movement for someone in the 30% slab. Arbitrage funds usually carry an exit load for redemptions in the first month or so; check the scheme's terms.

One to three years. Money market, low-duration and short-duration funds, or an FD, with the choice driven by how much a temporary dip would matter. For a like-for-like comparison with a deposit, the FD vs debt fund calculator takes your slab into account.

Whatever you choose, look at the fund's credit quality as well as its return. A short-term fund that earns more than its category is usually doing it by holding lower-rated paper, and that is where the rare large losses in debt funds have come from.

You can compare funds in each category on the liquid fund and arbitrage fund pages.

This post is for education only and is not investment or tax advice. Tax rules are as we understand them for FY 2026-27 and can change; past returns do not predict future returns.