Sinking funds are separate accounts into which periodic or lump-sum payments are made to accumulate funds to purchase the desired asset. It is generally accomplished by investing the funds in a low-yielding investment with a positive expected return. You can withdraw these funds without penalty as long as they are used for the same purpose and typically result in more tax deferral than other investments.
Sinking funds are designed to increase their investment value over time gradually. It is often used by investors who want to purchase real estate or other large asset investments but don’t have significant savings to buy them outright.
Importance
This kind of fund has both a tax and a liquidity effect. In the tax sense, the lump sum invested in the sinking fund investment yields capital gains when withdrawn and is subject to taxation at ordinary income rates.
Regarding liquidity, some investors have their entire retirement nest egg in a single account or even one investing company. Suppose an investor’s assets are invested with a particular company. In that case, they can incur fees (and likely give up liquidity and security) by keeping all of their assets with that source of investment.
It stabilizes your finances in retirement. Suppose you made up a substantial percentage of your portfolio in investments with low yields and high risk, like stock index funds. In that case, these percentages will rise significantly during market downturns. It can harm your portfolio’s overall performance.
If you need to pay off a loan or purchase an investment property in cash, using this fund is generally the best option for most investors, as it allows for more flexibility than simply withdrawing funds over time.
The long-term process builds up wealth that can be used as a fallback or live-off. Or you might use it to buy a home, pay for college, or when in retirement, you want to use the money to spend during your golden years.
It also improves your credit report. Your credit score will be affected if you have a public account with your checking and savings. The funds must be placed in the safest place possible to ensure a good credit rating.
How To Set Up
The first step is to choose an appropriate investment option. Understand what you are saving for; will you invest for immediate future use, like a down payment on a house, or is it for more long-term savings and investment?
The second step is to determine how long you plan to invest. Will you need access to the funds in the short or long term?
The third step is to decide what you want to invest the funds into. Sometimes, you have to leave options open for some time to ensure you get the best return possible. Other times this might be a final step as why you want it in there will depend on your situation.
The fourth step is to work the sinking fund into your budget. It is an easy step when you figure out the purpose of it, but it also serves as a great way to ensure your plan works with your overall financial situation.
Conclusion
Sinking funds are a great tool that should not be overlooked to build wealth or create a financial plan. It is important to determine what you want your fund to accomplish and how long it will take you before you can withdraw the funds. Most importantly, you can access the funds when you need them.
