In my financial planning classes, one of the concepts we cover is the Emergency Fund. I find it is very common to hear that the ‘ideal’ emergency fund for a married couple is 3 months of household expenses held in a savings account within a TFSA. I do not agree with this, and I will outline my reasons here.
First, I do not find that 3 months of expenses is necessarily the right amount. Just as we do life insurance needs analysis and retirement needs analysis, we can do an emergency fund needs analysis. I would suggest that 3 months of expenses is appropriate for a couple where both have reasonably stable jobs, lives in a relatively new house, drive cars that are not too old, and have no kids with special needs. There are other factors that might also come into consideration. I believe it is appropriate to carry a larger emergency fund where these sources of risk can be identified.
My greater concern, however, is the use of the TFSA. One of the reasons that I hear cited for using the TFSA is the tax efficiency. Let’s say that we have a $30,000 emergency fund, representing a fairly typical $10,000 of monthly expenses for a typical mass affluent financial planning client. The best possible high-interest savings account that I am aware of in Canada today provides a 1.7% rate of return. At 1.7%, a $30,000 account generates $510 of annual interest income. At a 40% marginal tax rate, which might even be on the high side in many scenarios, the actual tax cost of earning this interest is $204 per year. I like to think of the TFSA as a form of self-insurance. Yes, you could be earning greater returns on that investment. Yes, you could also be paying less tax on those investment returns. But those two things should be considered your insurance premium on this valuable form of self-insurance.
Now, you might say, “But Jason, if you’re not using your TFSA for anything else, then you’re still better off using it to house your emergency fund.” I would take exception to that. Consider that the purpose of an emergency fund is to provide funds for an emergency, and that we can’t always imagine the full scope of possible emergencies.
As an example, let’s say that Bill and Rachel, a happily married couple, are using their TFSA to hold $15,000 each. Now, let’s say that they are on a great vacation in Hawaii. Bill gets hurt quite badly in a ziplining accident, and ends up comatose in hospital in Hawaii. Now, they have travel insurance, so we shouldn’t worry too much about that. However, this really does limit Rachel’s ability to access the $15,000 sitting in Bill’s TFSA. If they had $30,000 sitting in a joint savings account, Rachel would be able to access the full amount. You might argue that Rachel would be able to execute the POA and access Bill’s emergency fund.
However, you now run into the complexity associated with getting doctors in another country to sign off on Bill’s loss of capacity. Even if this emergency doesn’t happen in another country, it still leaves Rachel with the additional stress of getting the POA executed relatively quickly. If the purpose of the emergency fund is to reduce stress, this seems somewhat self-defeating. Yes, the POA will have to be executed eventually, but it shouldn’t be Rachel’s #1 concern at this point.
In future articles, I will explore using the Line of Credit as an emergency fund, as well as behavioural concerns around the emergency fund.