PROSPERR.IO

When building wealth, creating emergency funds is one of the most important steps, so that if any emergency arises, you can remain undisturbed and let the funds continue to compound without interruption. 

How Much Should You Set Aside for an Emergency Fund?

There is no exact number that fits everyone's financial situation, but a practical approach is to aim for an emergency fund that covers 6 months of essential living expenses, including rent, groceries, utilities, EMIs, and basic medical costs. This ensures you can maintain your lifestyle even if your income stops unexpectedly.

And remember, building an emergency fund doesn’t have to happen all at once. Start small and stay consistent over time; even modest contributions can grow into a solid financial safety net.

Why is having an emergency fund important?

Life is unpredictable, and unexpected expenses such as medical emergencies, job loss, or urgent family needs can arise at any time. An emergency fund acts as a financial cushion, allowing you to manage such situations without relying on high-interest credit cards, loans, or disrupting your long-term investments.

It helps you stay on track with your financial goals by avoiding premature withdrawals from mutual funds, breaking fixed deposits, or stopping SIPs. Beyond just covering costs, an emergency fund offers peace of mind, ensuring you're prepared to face uncertainties with confidence and stability, without compromising your financial future.

Where to park your emergency funds?

There are two best options in mutual funds for parking your emergency fund: one that is safe and also generates some inflation-beating returns. You can keep it in Arbitrage funds or Liquid funds. Let’s compare both and conclude which one is better.

What are Arbitrage Funds?

Arbitrage Funds are a type of hybrid mutual fund that primarily invests in equity and equity-related instruments while taking advantage of price differences in the market. These funds capitalize on short-term arbitrage opportunities, such as price mismatches between the cash (spot) and futures markets or across different stock exchanges.

The fund manager simultaneously buys a security in one market and sells it in another, locking in a risk-free profit from the price difference. This strategy is fundamentally different from traditional equity investing, where returns depend on the asset appreciating over time.

Arbitrage Funds follow a low-risk strategy by exploiting temporary price inefficiencies across markets. Since profits per trade are small, fund managers conduct multiple trades daily to generate meaningful returns.

When such opportunities are limited, the fund may park its assets in low-risk debt or money market instruments.

Redemption Timeline: Typically takes T+2 days (Transaction day + 2 business days) to credit the amount back to your bank account.

What are Liquid Funds?

Liquid Funds are a type of debt mutual fund that invests in short-term fixed-income instruments, such as treasury bills, commercial papers, and certificates of deposit, all with a maximum maturity of 91 days. These funds aim to provide investors with safety, liquidity, and slightly better returns than a traditional savings account.

The primary objective of Liquid Funds is to preserve capital while offering quick access to funds. To achieve this, the fund manager invests in high-quality, low-risk debt instruments with short maturities, ensuring minimal sensitivity to interest rate fluctuations.

Since the maturity of the securities is capped at 91 days, the fund is less affected by changes in interest rates, making it a low-risk investment. The short-duration strategy helps maintain stability while delivering better returns than a regular savings account(sometimes), making Liquid Funds ideal for short-term parking of surplus money.

Redemption Timeline: Offer T+1 day settlement—money is usually credited the next business day.

Now, let's compare the risk metrics of Liquid and Arbitrage funds,

Beta: Beta measures how much a fund's returns move in relation to the overall market(Benchmark); a higher beta means more ups and downs compared to the market.

Standard Deviation: Standard deviation shows how much a fund’s returns fluctuate over time; higher values indicate more unpredictable performance.

The data used is category average data.

Liquid Funds have a low Beta and very low Standard Deviation, making them the most stable and least risky, ideal for short-term parking of money.

Arbitrage Funds also maintain low Beta and low Standard Deviation, indicating low risk with limited volatility, and are suitable for parking short-term money.

The data used is category average data.

Maximum drawdown refers to the largest decline in an investment’s value from its peak to its lowest point over a specific period. It indicates the worst-case loss an investor could have experienced during that time.

Arbitrage funds have the lowest maximum drawdown in the market. Liquid funds also have one of the lowest maximum drawdowns when compared to large-cap funds, which have a drawdown of ~28%, and small-cap funds, which have a maximum drawdown of ~41.5%.

Now let’s compare the returns of both the Liquid and Arbitrage fund categories,

The data used is category average data.

On the returns front, Arbitrage funds have outperformed liquid funds over the past decade, and we can expect returns from 4%(worst case) to 8%(best case) in arbitrage funds. And in Liquid funds, we can expect returns from 3%(worst case) to 7%(best case) based on the historical data.

Taxation in Arbitrage Funds vs Liquid Funds(As of June 2025):

Arbitrage funds are classified as equity-oriented mutual funds for taxation purposes and hence are subject to equity fund tax treatment under Indian income tax laws.

Short-Term Capital Gains (STCG): If units are sold within 12 months, gains are taxed at 20%.

Long-Term Capital Gains (LTCG): If units are sold after 12 months, gains over ₹1.25 lakh in a financial year are taxed at 12.5%.

For Liquid funds, all capital gains are taxed at the slab rate, irrespective of the holding period. These gains are added to your income and taxed as per your applicable income tax slab. No indexation benefit or long-term capital gains tax treatment is available.

Savings accounts and flexi fixed deposits are also among the best options to park your emergency fund, offering decent returns with high liquidity and easy access to funds when needed.

Flexi FDs:

Flexi FDs are hybrid savings instruments that combine the high interest of a fixed deposit with the ease and liquidity of a savings or current account. Funds beyond a set threshold in your linked account are automatically swept into an FD, while withdrawals break the FD partially when needed. You can access funds without disturbing the whole deposit.

Flexi FDs offer the sweet spot of better returns than savings accounts, liquidity on demand, and automation, ideal for managing idle cash efficiently while keeping your funds accessible in emergencies.

Taxation in Flexi Fds(As of June 2025):

Interest earned from Flexi Fixed Deposits is added to your total income and taxed under the head ‘Income from Other Sources’ in your Income Tax Return. The applicable tax is calculated based on your income slab, and it may vary depending on the tax regime you choose, your age, and your residential status.

Savings Account:

Parking your funds in a regular savings account can generate modest returns in the form of interest, which may vary depending on the bank and the balance maintained. While not a high-return option, it offers liquidity and convenience, making it suitable for holding short-term funds or maintaining an emergency buffer.

Source: Policy Bazaar(July 2025)

Interest earned on a savings account is taxable under the head ‘Income from Other Sources’ and is taxed at your applicable income tax slab rate.

Conclusion:

After evaluating various options, arbitrage funds offer better post-tax returns, particularly for investors in higher tax brackets. This combination of safety, decent returns, and tax efficiency makes arbitrage funds an excellent option for parking money you might need in emergencies or for short-term goals. They strike the right balance between keeping your money safe and helping it grow modestly. 

However, they fall short in terms of immediate liquidity. A balanced approach would be to split emergency funds between two instruments, one offering high liquidity (like a flexi FD, Liquid fund, or savings account) and another in arbitrage funds for slightly higher, inflation-beating returns. That said, the ideal mix may vary depending on an individual’s cash flows, lifestyle, and overall financial situation.

Prosperr.io is a simple platform to manage your personal income tax. It helps you save and automates tax tasks. It gives you the knowledge to make smart financial choices, keeping your money where it belongs. Click here to book your FREE tax assessment call 

Disclaimer:

The information provided in this blog is for informational purposes only and should not be considered financial advice. Please consult with a financial advisor before making any investment decisions.