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Financial planning

How big is your emergency fund? Add to ...

To be an investor, first you must be a saver. This is a rather self-explanatory concept. But before you can become a saver, you need to disaster-proof your life. This concept is less well understood.

You have your whole life to accumulate wealth for you and your family, and quite frankly the recipe is pretty straightforward: Spend less than you earn, invest the surplus in something not too crazy, and then wait.

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Of course a lot of things can happen between now and retirement that can prove fatal to your long-term plans. You could lose your job and be out of work for an extended period of time. You could get into a serious accident. You could die. Any of these things could happen tomorrow. In contrast, retirement can be decades away.

Sometimes we need to realize that we should give up the chance of "making a killing" in exchange for never "getting killed" by one or more of these disaster scenarios. That means socking away slightly less for retirement and directing money to proper insurance policies to address catastrophic risks and toward a small emergency reserve for the not-so-catastrophic risks.

Notice I said a "small" emergency reserve. Depending on whom you talk to, the rule of thumb is to hold anywhere from three months worth of expenses to 12 months worth of income in your emergency fund.

Twelve months worth of income could be over $100,000 for some households. I can't imagine putting that much money aside in a savings account as a safety net - especially if you have a balance on your mortgage or credit cards. Imagine how much faster your mortgage could be paid off with a lump-sum payment that big.

For that same household, three months worth of expenses could be $10,000 or less. That's generally going to be plenty for most people, especially if you are doing all the other things you're supposed to (insurance, investing, etc).

For example, if you contribute regularly to an RRSP and you run into an emergency, isn't that going to be one place to access emergency funds? If you are in an emergency situation for more than three months and have exhausted your emergency reserve, chances are your income is going to be much lower than normal for that tax year - which puts you into a lower tax bracket. Withdrawing money from your RRSP could be subject to a lower tax rate than the deduction you earned when you put it in.

Many people count their TFSAs (tax-free savings accounts), RRSPs, home equity, open investment accounts and unused lines of credit as emergency reserves. Lines of credit may or may not be available when you need them, but the other sources are perfectly valid.

That being the case, as you get closer to retirement your need for an emergency reserve funded by a savings account decreases.

Unless it causes you to lose sleep, keeping three months worth of expenses in a high-interest savings account will provide you more than enough for an emergency reserve.

Follow on Twitter: @preetbanerjee

 

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