Life can take you by surprise. You might be hit with a job loss or disability for a period of time, or your spouse or child gets sick. Or maybe the roof starts leaking and it costs $20,000 to replace, just as the twins need braces. That's where a contingency fund can save the day – and sometimes, literally, the house.
Contingency funds are usually meant for a non-reoccurring and unexpected expense, so it's key to be able to get your hands on the money right away. It's a good idea for individuals and families to plan for such a fund before trouble hits so you can protect your most important assets during a crisis. But the challenge is how to structure contingency funds so they're still working for you in terms of an investment but can be easily liquidated without major tax consequences.
"If you need an emergency fund and you want it as liquid as possible, then you probably have to accept that liquidity equals low return," says Adrian Mastracci, president of KCM Wealth Management Inc. in Vancouver. "The rates and what you look for in a long-term investment are not the same as what you look for in an emergency fund investment. It won't be quite as good."
Safety is another important factor for any contingency fund. According to Jamie Golombek, managing director of tax and estate planning for CIBC Private Wealth Management in Toronto, there are few investment options that keep money both readily available and safe.
"The point of a contingency fund is not to make money on it, but to make sure it's there in the case of emergency, Mr. Golombek says. "If you need the money to be there, you should not be in equities or anything that's volatile. You need something that's easily cashable on a day or two's notice."
Contingency funds don't have to be large to be effective. Mr. Mastracci suggests that most people would be okay with three to six months of budgetary expenses, although people with a higher net worth would likely need a larger fund.
So what are some of the best choices?
"From an investment perspective, there's a savings account, which is always available and safe but pays a very low interest rate," Mr. Golombek says. "Plus there are money market mutual funds, which are pretty safe but also pay a low rate of return. What matters is those can all be liquidated within a couple of days."
Noting that cashable GICs and bonds can be sold quickly "without dickering on the value of the assets," Mr. Mastracci points out that while you get the least return, at least you know it's there.
"If you need peace of mind, that's the way to go," Mr. Mastracci says.
An alternative solution that Mr. Golombek recommends to clients is setting up a secure line of credit on your home as an immediate way to access cash for a very low cost. That way you're not tying up money in short term "what-if" emergency funds.
"Interest rates are linked to prime, and prime is at an historic low right now," Mr. Golombek says. "By using a secure line of credit, you'd have a source for emergency funds. The point is not to draw on that line but only to access it in case of an emergency. You only pay to the extent that you borrow, and then pay it down as soon as you can to avoid the additional interest cost."
That's what Mr. Golombek did himself "the minute he bought his house," securing the maximum line of credit that the bank would give him. He doesn't use it, but likes knowing it's there if he needs it.
While Mr. Mastracci agrees that a line of credit is a viable option, he cautions that things may change with little or no notice because "banks do things like that." Using the overdraft on your chequing account is another possibility, but that comes with a high interest rate.
Since not all people are comfortable with credit or can get credit, Mr. Golombek recommends that the TFSA – the tax free savings account that allows you to earn investment income completely tax free – could be used as an emergency fund.
"You could save three months salary within a TFSA and invest that in something secure such as a cashable GIC," says Mr. Golombek. "You can access that money instantaneously and won't pay any tax at all on the interest income. But again, you're looking at very low rates. If you want easy access to money, you're talking around one per cent on average."
From a tax perspective, Mr. Mastracci warns that an RRSP does not work as a contingency fund because if you take money out of an RRSP, it's taxable. His firm offers clients – for their non-RRSP personal accounts – what's known as a margin account, which means that they can borrow from it, much like an overdraft. Most brokerage houses offer the same sort of thing, he says.
"There are no tax consequences as long as you simply borrow," Mr. Mastracci says. "The tax comes along if whatever you sell to cover the overdraft has a capital gains or capital loss that you have to deal with. But you don't incur the tax consequence until you actually sell the assets that you have in your account."
A little advice
Adrian Mastracci: "Only cash in an RRSP as a last resort. You can't put the money back in, and it's taxable when you take it out."
Jamie Golombek: "If it's a contingency fund, I would avoid any kind of stock market or equity risk. Period."
Adrian Mastracci: "Make sure that the cash you use for your contingency fund is not at the same institution where you have a loan or credit card. It can happen that they'll take your cash and put it against your liability. Then your rainy day fund is gone."