Emergency funds are a great way to protect yourself from unexpected expenses or a sudden job loss. But where do emergency funds fit in your financial life? Is an emergency fund better than a savings account?
Emergency funds are a savings account that is set aside solely for emergencies. It can be held in a savings account, but it should be separate from other savings funds. Other savings funds may be earmarked for a car, home, vacation, etc., but an emergency fund is held for only unexpected expenses.
It’s important that you have enough in your emergency fund to cover an urgent expense. There’s also considerations for the best place to hold it. Read on to learn more.
Are Emergency Funds and Savings Accounts the Same Thing?
For the purposes of this article, I’m going to separate savings accounts vs. savings funds. Savings accounts are accounts offered by your bank to hold funds. They typically have a higher interest rate than a checking account. Savings funds are pools of money that you have set aside for a specific purpose. This could be saving for a car, a downpayment on a home, or a vacation. Savings funds can be held in a savings account.
In terms of setup, emergency funds and savings funds may be the same – both held in a savings account. But they should be treated separately, and held in different accounts (left example below). I.e. you should not have a single savings account where you hold both emergency money and your vacation savings (right example).
Keeping this separation helps ensure that your emergency fund is only used for emergencies. Your emergency fund should only be used for unexpected expenses that need to be taken care of. For example, if your car or home needs an emergency repair. Or if you lose your job and need to pay bills while you find a new one.
When your emergency fund is not separate from other savings account, it becomes much easier to dip into it for non-emergencies. For example, in the image above, you may plan a vacation and find it actually costs $3,500. When the vacation money is in the same place as your emergency money, you may take some from the emergency money. Whereas when they’re separated, it’s much more obvious to you that the money should not be used.
It’s important that you keep your emergency money separated from other savings funds. This helps protect it for when it’s truly needed.
What is the Best Emergency Fund Account?
The best emergency fund account is both liquid and safe.
The best emergency fund account is a high-interest savings account. It allows for some growth on your money, while keeping it easily accessible and in cash, and protecting it from losing value. Illiquid or risky investments, such as stock market investments or GICs should not be used for an emergency account.
Liquidity means that the money is readily available in a usable format when you need it. An example of an illiquid investment is a car. There may be value in your vehicle, but it’s not easy to turn that value into usable cash. A liquid account is one where you’re holding cash, such as a savings account. Having your emergency fund liquid means that you can quickly deploy money to deal with any emergency.
Your emergency fund should also be safe. That means that the money is there when you need it, in the amount that you expect. When you invest in the stock market, there’s possibility that the value drops. If this drop coincides with when you need the money (e.g. a stock market drop coincides with a job loss – not uncommon), that can be disastrous. Your emergency fund should be held in an account that will not decrease in value.
High-yield savings accounts provide both a safe and liquid account, while also providing some growth. The growth will not be as high as other investments, but your emergency fund is not intended for growth, but rather to protect you in case of emergency.
Should I Use a Registered Account for my Emergency Fund?
In general, registered accounts (such as TFSAs or RRSPs in Canada, IRAs in the U.S.), should not be used for an emergency fund. Registered accounts can come with withdrawal limits that mean you are penalized for accessing the money. They can also have tax advantages which are better suited for investments.
For example, in Canada, RRSPs (similar to a 401k) provide benefits in terms of tax-deferral, but accessing the money before retirement comes with significant taxation. Not only are the withdrawals taxable (meaning you’ll pay your marginal tax rate on the withdrawal), but there is also a withholding tax for withdrawing before retirement. This withholding tax can be up to 30%! Imagine having an emergency where you need to access your emergency funds, only to find you need 30% more than you thought to cover the taxes. Emergency funds should not be held in an RRSP.
TFSAs (similar to Roth IRAs) are another registered account which allow for tax-free growth on investments. TFSAs don’t have any withdrawal limits, but they do have contribution limits. As such, generally TFSAs should not be used for emergency funds either. TFSAs can be a very powerful tax saving mechanism, but the contribution limit means it can only be used for a set amount of money. By holding an emergency fund in a TFSA, you are preventing yourself from using that space for investments. The returns (and subsequent tax savings) of investing will be much higher than those of an emergency fund (which should be held in cash). You’re best to use your TFSA for investments, and keep your emergency fund in a non-registered account.
With an emergency fund, you want it safe and liquid. As such, you don’t want any restrictions on accessing it when you need it, and you shouldn’t have it in a higher-risk, higher-return investments. Registered accounts are best used for investments, which take full advantage of the tax advantages, and are held for the long-term.
How Much Should I Have in My Emergency Fund?
In general, you should hold 3-6 months worth of living expenses in your emergency fund. This is enough to cover an unexpected expense or job loss, while not holding too much in cash. The exact dollar amount to hold will depend on your individual lifestyle and circumstances.
For example, if you own multiple assets (e.g. car or home) that could have emergency repairs or have dependants (e.g. children), you may hold more in your emergency fund. Similarly, if you work in a volatile job/sector where layoffs are not uncommon, it’s wise to provide yourself a bigger safety net.
On the other hand, if you don’t have any major assets that could need repairs and have no dependants, you may be able to get away with having a smaller emergency fund. As well, if you have a safety net (e.g. parents nearby) that could support you if you run out of funds, your emergency fund could be smaller.
It’s important that you assess your individual circumstances to determine the dollar amount that works for you. To find out how to budget for an emergency fund, read more here.