Why Every Canadian Needs an Emergency Fund
‘Failure to plan is planning to fail’ - Benjamin Franklin
If you dont have an emergency fund set up, you already have an emergency… well, sort of… Hear me out. Unexpected expenses are not an ‘if’ but a ‘when’. An issue with the house or car, a family issue, unexpected time off work, or even an unexpected pet expense (if you have one) can put you in a financial jam.
If there is no reserve fund for these unexpected expenses, it usually means incurring debt, which can be a significant setback, especially if all the unexpected expenses accumulate over the years.
‘Failure to plan is planning to fail’ - Benjamin Franklin
This old quote couldn't be more true when thinking of an emergency fund. The emergency fund is a foundation of the financial plan. It will help your plan stay on track when those unexpected expenses arise and will help you avoid nasty credit card debt and expensive interest costs.
Once youre retired, the emergency fund takes on a whole new meaning. There's typically less flexibility for income, and you don’t want to spend your golden years recuperating financially. Having an emergency fund will prevent you from digging into your lifestyle savings. And what if investments are down when you need the money most?
Let’s ensure your emergency fund foundation is rock solid before moving on.
What Does an Emergency Fund Look Like?
The concept is straightforward:
Have 2-6 months of income saved if paid salary
Have 6-9 months of income saved if self employed
Have 1-2 years of investment income saved when retired
Have these savings in lower risk accounts/investments
How to Optimize the Emergency Fund:
How you optimize the emergency fund will depend on your unique situation and goals. However, one overarching feature that applies to all emergency funds is to ensure the highest rate of return, along with the lowest risk investments.
Where to invest your emergency fund?
Examples of such investments are Short Term Bond ETFs, such as ticker SHV (currently paying ~ 4.11%), or an instrument such as ticker CASH on the Toronto Stock Exchange (currently paying 4.04%).
Because these investments pay tax inefficient interest, it makes sense to hold them in your TFSA to avoid high income taxes.
However, as important, holding funds in a TFSA adds a ‘protective layer’ that keeps the money at some distance from everyday spending.
On the other hand, having the funds readily available in a chequing or savings account may be too tempting when that once-in-a-lifetime deal on an ATV comes up or that 50% off cruise to Burmuda looks too good to pass up. Having to jump through a couple of hoops to access the funds can help us to think twice.
Depending on your situation, optimizing the savings level could look different. Consider the following as an approximate guideline:
Single, salaried income earner: 4-6 Months savings. If there's time off work or a high expense, you’ll want a more substantial backing because your ability to weather and recuperate is squarely on you.
Dual income, salaried: 2-3 Months savings. Because there are two incomes, if one takes a hit, the other income is there to help. There are also typically more shared expenses, making savings and recuperation more manageable.
Self Employed: 6 months minimum. Some will want upwards of a year's worth of income saved. If you're self-employed, you probably get it. Even the best businesses have their ups and downs, and when the market shifts, of course, that's when the house needs a significant repair.
Retirement: 1-2 years of annual income minimum, as we’ll see below.
How does the emergency fund fit into the rest of the financial plan?
Budgeting:
Especially if self employed, with variable income, or if retired, a budget can help you understand basic monthly expense requirements. It's possible that daily spending is a bit higher than it could be if a financial issue arises.
What are the expenses you can and can't give up for a few months?
Or if other financial constraints are making it difficult to save up a larger emergency fund, consider a slightly pared down version based on leaner spending and go from there.
Debt and Mortgage Management:
The best interest rate is 0%, and the only way you’re ever going to get this is by avoiding debt in the first place. This includes avoiding the use of Home Equity (HELOC) to fund emergencies, unless you are retired and looking to downsize eventually.
It can be hard to save for short term costs that we dont yet know will happen, but ironically, avoiding inevitable emergency expenses can be the most profitable, growth oriented decision you can make.
Retirement Planning:
Typically, during retirement, income is limited to some extent or ‘fixed’, based on savings and available pension. So spending becomes more of a ‘zero sum game’.
Given this, the idea of having an emergency fund is even more important when you are retired.
Financial planners often evolve the idea of an emergency fund into the concept of ‘guardrails’ for the financial plan or a ‘war chest’ for retirement.
If there's a major expense, you won't need to cash out RRSPs, triggering high income taxes and potentially throwing off an entire financial plan.
Or if the market drops during retirement, you don’t want to liquidate your higher risk/return investments at their lows. So you have your conservative emergency fund in a TFSA that you can spend from for 1-2 years while the market recovers.
Income Tax Planning:
Major expenses before or during retirement, like a vehicle purchase or dream vacation, can spike income tax if income rises significantly in a year from cashing in more RRSPs, or creating other taxable income. But by having funds in a low risk, lower volatility TFSA account, you'll save on taxes while ensuring the funds are there when needed.
So two fundamental tax planning tips: (1) Minimize taxes on your emergency fund savings. Its optimal to hold interest earning investments in a TFSA to keep taxes lower (2) Use the evolved concept of ‘retirement guard rails’ or a ‘retirement warchest’ to pay for significant expenses in retirement, out of a TFSA, therefore avoiding cashing in RRSPs or other tax heavy options, to pay for significant expenses. Keep that marginal tax rate nice and low and save thousands on income taxes.
Investing:
Based on the ideas above, the investments should be low risk. However, this can form the low risk portion of your balanced investment portfolio (along with potentially CPP as a low risk component of your retirement plan). Consider having your low risk investments in the emergency fund and higher risk, higher potential return investments in your RRSP and other areas of your financial plan.
Estate Planning:
From an income tax perspective, the savings you’ll want in the end is a low risk TFSA. Why? On your year of passing, all RRSP and non registered assets are taxable. For example, if you have $100,000 of RRSP assets, they are all cashed out at once, resulting in a massive tax bill to your estate. That's a major benefit to CRA, and a setback for your estate.
Yes, there are spousal rollovers that may be applicable, but they can have limitations. We’ll touch on those subjects later. In the end, you'll want safe, low volatility assets and minimal income taxes on your estate. If youre going to have final assets, you want a TFSA to keep funds in your family and away from income tax.
Ready to Build Your Emergency Fund?
Start small, but start today. The emergency fund is one of the foundational components of a reliable financial plan, and is one of the simplest, straight-forward ways to create peace of mind and promote interest savings.
Even setting aside just $50 or $100 a month can add up quickly.
Automate your savings to align with your pay day
Open a separate TFSA account with your bank or online broker.
Ideally, the target amount for the emergency fund is reached within 2-3 years. If 3 months income after tax is $30,000, divide the amount by 24-36 months to reach a monthly savings target (ex. $1,250 - $833).
But remember, anything is better than nothing. If 3 months savings is unfeasible currently, start with 1 month's savings.
If an unexpected expense happens, you'll see the immediate benefit of the fund. Start replenishing the next month.
Once you've reached your emergency fund target, use these savings to manage your debt and/or save for retirement.