Emergency funds are an important part of your financial life, but you should not hold it in a tax-advantaged account like a TFSA.
Tax-advantaged accounts are great for reducing the taxes you pay on investment growth, and by using up the limited contribution room for holding emergency cash you’re wasting that opportunity. Emergency funds should be held in cash, and the growth and subsequent taxation will be minimal. You’re better keeping your emergency fund in a separate account, and taking full advantage of your tax-advantaged accounts.
You don’t get a lot of tax breaks in Canada, so take full advantage of them where you can.
What Happens If You Hold Your Emergency Fund in a TFSA?
There’s no penalty for holding an emergency fund in a TFSA, but there can be a pretty significant opportunity cost.
Emergency funds should always be held in cash and not invested, that way the money is there when you need it. As such, the growth you get on your emergency fund will be marginal (maybe a couple percent at best), and the amount of tax you pay on such growth will be negligible.
TFSAs have contribution limits, so when you take up some of your TFSA for an emergency fund you are preventing yourself from using that room for investments. For example, by holding $10,000 of emergency fund in a TFSA, you’re preventing yourself from taking advantage of that $10,000 of room for investments. This effect gets amplified the longer you are taking up that room. Let’s imagine on that $10,000, you could you could achieve a 8% return on an investment, and a 1% return on your emergency fund savings account. Over a 20 year time frame, your emergency fund will grow to $12,201.90, and the investment would be $46,609.57. Would you rather pay taxes on a gain of $2,201, or $36,609?
By using your TFSA for an emergency fund you’re either forcing yourself to invest in a non-registered account, or maybe it means your not investing at all. You’re missing the opportunity to use the true advantages of registered accounts. I don’t mind paying tax on the small growth in my emergency fund if it means I don’t pay it on my investment gains.
Emergency funds in TFSAs will cost you the additional taxes on investment gains, or will cost you in the form of not investing at all – reserve your TFSA for investments.
Where Should You Hold Your Emergency Fund?
Because your emergency fund is for when you need money urgently, you want it somewhere liquid and safe.
As such, you don’t want it in a place where you’re penalized for withdrawing. TFSAs don’t have an explicit penalty, but any time you make a withdrawal, you won’t be able to reuse that contribution room until the following year. As such, you should hold your emergency fund in something accessible, like a non-registered High-Interest Savings Account.
Holding your emergency fund in a high-interest savings account means you’ll have some (small) growth on the money, it’ll be readily available with no implications for withdrawing, and you can take full advantage of your TFSA for investing.
What Should You hold In a TFSA?
The biggest advantage of a TFSA is there is no tax on the gains.
As such, you want to maximize how much money can grow, and how much time it has to compound. Now there are a lot of different ways to invest depending on risk tolerance, but you should absolutely be invested in the stock market. Holding cash in a TFSA is a wasted opportunity.
Your TFSA should be used for investment, regardless of what strategy you want to employ.
Conclusion – Don’t Hold Your Emergency Fund In a TFSA
You should not be holding your emergency fund in a TFSA. By doing so:
- You are wasting opportunity for tax breaks
- There are side effects of withdrawing from a TFSA when you need your emergency fund
- You are not taking full advantage of the purpose of the TFSA
Hold your emergency fund in a high-yield savings account, and use your TFSA for investments.