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Mixing growth funds and fixed term annuities "Mixing growth funds and fixed term annuities could be the answer for savers faced with the prospect of renewing GICs in low interest rate environments." It is called reinvestment
risk. In addition to a lower interest rate, it is the actual loss
of buying power of the original capital over time due to inflation. So,
what should you do if you're in this situation? Should you stay with the
certainty of GIC
investments and adjust your lifestyle if need be, or take the plunge into
the mutual
fund pool or perhaps buy some stocks and then worry about the uncertainty
of the markets and your capital? The following is a suggestion that you can use in your
investment
portfolio to provide a good measure of certainty, good after tax income
and the potential for growth of your capital over time. It is not perfect
as you will see, but then again, in reality no investment is. Say you have a $50,000 GIC that has come due and the
best rate available for renewal is 5.5%. Your annual interest income would
be $2,750, which in a 42% tax bracket would only leave $1,595 after tax
which doesn't amount to much at all. As an alternative you could take half of the capital,
or $25,000, and invest it in a 10 year product that would generate approximately
$3,036 of income each year, of which only $543 is taxable. At the same
42% tax bracket this would leave about $2,808 annually in your pocket
after tax. This is substantially more than the GIC option and you are
using only half the capital. The investment is called a prescribed annuity which is available from most life insurance companies. The figures given are approximate because the market is competitive and values will vary depending on market conditions. The good part about these type of annuities is that
you will achieve a good measure of certainty with a 10 year stream of
tax preferred income (terms other than 10 years are available). The downside
is that after the end of the 10 year term, your original $25,000 capital
will be gone. The high tax preferred income is largely based on a return
of your own capital, which is not taxable. Now before you write this suggestion off as being crazy, remember that it only involves half of the original $50,000 capital. There is still the remaining $25,000 to deal with. For this amount, I would consider investing in an international mutual fund(s) with emphasis on tax efficiency. Leave the investment alone for the same 10 year term as the annuity and allow it to grow. If we take a conservative assumption of an average compound rate of return of 8% for the ten years, the $25,000 will grow to $53,973, replacing and surpassing the original capital. It is important to use a growth fund and not an income producing fund such as a mortgage fund or bond fund because the objective is growth instead of income. International funds will spread your investment over several economies, reducing your market risk. Tax efficiency is important because you do not want a lot of trading activity by the manager that will generate a large T-3 capital gain liability. You goal should be to minimize any tax liability on the invested $25,000 of capital until such time as you are ready to draw on it. There are several mutual funds available that meet this criteria. The upside of this is the potential for good growth of your capital over time and the fact that you have a 10 year time frame to work with so you shouldn't be as worried about market fluctuations. The downside is the future value is uncertain. As you can see, the above suggestion isn't perfect but it can provide an alternative of good tax preferred income and growth for consideration.
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