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Financial planning tips

November 20, 2018

How to build your emergency fund

You might not be able to predict a financial emergency, but you can prepare for one. Here’s how you can be ready for life’s surprises.

It’s an uncertain world.

No matter how careful you are with your money, there’s no way of predicting the unexpected expenses that life can toss your way. From replacing your car’s transmission to putting in a new furnace, everyone runs into a financial emergency – a major expense you didn’t anticipate but can’t postpone – from time to time. But not everyone is prepared for it.

A recent survey by the Financial Planning Standards Council (FPSC) found that of 1,527 Canadians polled, 33% would fail what the FPSC calls a “financial stress test.” That simply means that many Canadians believe they don’t have the financial resources to handle an unforeseen event, such as a sudden health crisis, the loss of a job or even an urgent visit to the vet. 

If you’re feeling similar concerns or you don’t have a financial contingency plan, now is a good time to reach for financial peace of mind. To mark Canada's 10th annual Financial Planning Week (November 18-24 this year), here are some solid steps you can take to build an emergency fund that will help you sleep better at night, knowing you’re prepared for unforeseen bills and expenses.

4 tips for building your emergency fund

1. Take small steps toward saving

As a general rule, you should have enough in your emergency fund to cover up to six months of your living expenses. For many people, that means salting away $30,000 or more. But aiming for a large, lump-sum savings goal like that can be discouraging. Instead, try building your savings in small steps. Take a realistic look at your income and your spending, and figure out how much you can actually afford to set aside right now. Maybe you can only put away $20 or even $5 a week right now. That’s a good start. Simply choose a set amount per week or month that you’re comfortable with and arrange to have it automatically transferred from your chequing account or taken right off your paycheque, if your employer offers a workplace savings plan. Review the arrangement regularly, and increase the amount you’re saving, if you can.

  • For a clear picture of what goes in and what comes out of your bank account, try our budget calculator.

2. Keep your emergency fund separate from other savings

Let’s say your furnace quits in the middle of a cold snap, or your SUV blows a head gasket while you’re on a cross-country road trip. If you’ve built up a healthy sum in your retirement savings, you might be tempted to raid those savings to pay for that emergency. But here’s why you shouldn’t: It might cost you more in the long run.

For starters, all withdrawals from registered retirement savings plans (RRSPs) (except for education and home purchases, under the Lifelong Learning Plan and the Home Buyers’ Plan, respectively) are subject to income tax and will result in the permanent loss of contribution room – that is, once you’ve taken it out, you can’t put it back in. Any withdrawals from your RRSP are immediately subject to withholding tax. If you withdraw up to $5,000, the withholding tax rate is 10%. If you withdraw between $5,001 and $15,000, the withholding tax rate is 20%, and more than $15,000, the rate is 30%. These tax rates apply in all provinces except Quebec, where provincial tax rates apply on top of the federal withholding tax.

There’s more: Whatever you withdraw from your RRSP is also included in your taxable income for the year, so if your marginal tax rate is higher than the withholding tax rate, you’ll have to pay more on the money you’ve withdrawn, the following spring.

The bottom line: In order to avoid dipping into your retirement savings, be sure to stash your emergency funds in a separate account. 

3. Don’t rely on debt

Feel the urge to reach for your credit card whenever you’re in a jam? It’s tempting, yes, but try to resist. Remember that credit cards charge high interest rates when you don’t pay your balance in full every month. And while using your line of credit for fast cash seems ideal, remember that it’s still money you have to pay back. The interest rate might be lower, but the debt is still there.

For emergencies, you’re better off avoiding the plastic and depending on your savings instead.

4. Consider opening a savings account

The ideal emergency fund lets you see your money grow AND get access to it quickly and easily, in which case your best bet could be a tax-free savings account or a high-interest savings account. Your choice might depend on which is more important to you: potential growth or ease of access.

With a tax-free savings account (TFSA), you can grow your money with various kinds of investments, including bonds, stocks, mutual funds and exchange-traded funds – not just cash. Your investment return could potentially be in the high single- or even the low double-digits, if your investments perform well. Or you could lose money, if they don’t. Just keep an eye on your contribution limit, which currently stands at $5,500 per year, in addition to whatever you had withdrawn from your TFSA in an earlier year and are now re-contributing. Unlike RRSP contributions, your TFSA contributions aren’t tax deductible. But because you’ve already paid income tax on the money you put in your TFSA, you won’t have to pay tax when you take it out. And any investment income you earn won’t be taxed – not even when you take the money out of your TFSA.

While a TFSA offers tax-free growth, the restrictions on the investments you hold in it might mean it will take a few days to withdraw your money. This could be highly inconvenient if the rain is pouring through the hole in your roof in the meantime, or your car has broken down hundreds of miles from home.

To cover such situations, you could keep some money in a high-interest savings account. While these don’t offer the growth potential of a TFSA because you can’t hold investments in them, they do pay slightly more interest than an ordinary savings account. The interest you get depends on your bank and your balance. Since your money isn’t locked in, it’s much easier to get at when you need it. Unlike a TFSA, there’s no limit to the amount you can put in a high-interest savings account, but you do have to pay income tax on the interest you earn. Note that you can have a registered high-interest savings account itself as a TFSA, in which case TFSA contribution limits and tax treatment apply.

Not sure what’s right for you? An advisor can help you decide which savings option (it could be more than one) can help you grow your money during good times and have it on hand when hard times come along.

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