A common financial advice is to save 6+ months of living expenses as an emergency fund. But once you have accumulated the corpus, what is the best way to park it?

There are three aspects one should keep in mind when deciding where to invest:

  1. Safety
  2. Liquidity
  3. After-tax Returns

Safety is Critical

Ensuring that your emergency corpus is never subject to the vagaries of the market is of the utmost importance.

Since risk and return are inseparable, you should stay away from potentially high-return instruments like equities, long-term government or low-quality corporate bonds.

Liquidity is Important

What is the point of having an emergency corpus if you can’t access it when you need it the most?

Thus, you should also avoid financial instruments with lock-in periods, such as the Public Provident Fund (PPF) or 5-year Tax Saving Fixed Deposits.

Instant Access is Overrated

While multi-year lock-ins are one extreme of the liquidity scale, the other is instant access. Since timely access to money can be crucial, you might believe that you need to ensure instant access to the entire pot, but that’s not true.

One can group the urgency of money in unfortunate circumstances into two categories:

  1. Immediate: For example a family member is hospitalized.
  2. Within a few days: Such as home or vehicle repairs, or job loss.

Even in situations requiring immediate access to funds, one rarely needs the entire corpus right away. For instance, in cases of medical emergencies, hospitals often demand an upfront deposit but that is seldom a large amount, especially if you have a health cover. The more money the treatment requires, the more serious is likely the illness, which means a longer hospital stay, and more time to arrange the funds.

A limited need for immediate liquidity is advantageous because instruments providing instantaneous liquidation offer lower returns. Think 4% yield on savings bank accounts or 1% premature penalty on top of a <7% interest on fixed deposits.

But Don’t Forget About Taxes

The final aspect you should care about is making sure that the returns exceed or match inflation even after taxes. Otherwise, your corpus will bleed its purchasing power every year.

Unfortunately, all instruments that are safe and offer instant liquidity—such as savings bank accounts, fixed deposits, and liquid funds—are taxed at the marginal slab rate. If you fall under the 30% tax bracket, a 6% return translates to a mere 3.4% return after taxes, which is less than the inflation target of RBI (4 to 6% p.a.).

A Better Way to Park The Money

To make the most of your emergency corpus, the trade-off between speed of access and the after-tax returns needs to be carefully managed. One way is to split the corpus into two parts:

  1. Allowing instant access
  2. Optimised for After-Tax Returns

Instant Access

Because of the lower returns (liquidity premium and poor tax treatment), only a small part of the corpus should be invested in instruments that allow access to funds without delay.

Fixed Deposits with any of the big banks are a good option despite the premature withdrawal penalty. They can be redeemed online and have no limits on instant withdrawal, unlike liquid funds. You can pick two to three-year terms as they often have the highest rates.

An Unconventional Alternative

While FDs offer a traditional solution, I follow a non-standard approach — lean on my credit card instead. The high limit on the card can also help me manage much larger outflows. Between my wife and I, we also keep a few tens of thousands of rupees in our savings accounts, which come in handy at places where credit cards are not accepted.

Once the urgent situation is handled, we redeem our mutual fund investments to pay the credit card bill in full or refill our savings accounts.

Optimised for After-Tax Returns

Instruments that provide favourable after-tax returns should receive the bulk of the corpus, even if there is a slight delay in accessing the money.

Given the considerations, I have found arbitrage funds to be a great choice as they:

  1. Offer similar returns to two to three year-term FDs but with 10% tax on LTCG and 15% on STCG. In the last three years, the category average has hovered close to 6%, i.e. 5.5% after taxes.
  2. Fall under the lowest risk category of mutual funds, as per SEBI, and are considered safer than liquid funds.

I used to prefer money market funds earlier but have moved away after the recent changes in tax laws.

Redemption of arbitrage funds is handled on T+2 days. But if you file a request on a Friday or around bank holidays, the money may take 4-5 days to arrive in your bank account.

One disadvantage of arbitrage funds is that their returns are not predictable. Unlike FDs, they change based on the short-term interest rates set by the RBI.

Spreading the money across different investments requires more effort than putting everything in one place but can protect your corpus from inflation without losing the flexibility to manage emergencies.