In my last post about emergency funds, I covered a number of good reasons why I prefer to use a line of credit for my emergency fund instead of having cash.
Some reasons I listed were:
- Tax inefficiency – interest payments on the cash are taxed at the marginal rate.
- Better uses for the money – either paying off debt or investing at higher expected returns.
Since I published that post a couple of months ago, the Canadian government has introduced a new tax-free savings account (TFSA) which basically allows Canadians to save money in an account where none of the earnings (interest, dividend, capital gains) are taxed.
This is a big development because one of the main reasons I don’t like keeping too much cash around is the high taxes that I have to pay on the interest. With the introduction of this new tax-free account, my reasons for not having a cash emergency fund have been greatly reduced.
The other great benefit of the tax free account is that you can save up for large purchases, such as cars, vacations etc and you don’t have to worry about the tax issues from earnings.
New emergency fund strategy
We’ve decided that once the new tax-free accounts become available (in 2009), we will start up an emergency fund which will also double as a savings account for our next car. Since we still have a large mortgage that we want to dispose of as soon as possible, this emergency fund won’t be very large. I’m thinking of maybe starting it at $5,000 and accumulating it up to about $10,000. At that point it will be around three months expenses. The new strategy will be a combination of cash emergency fund and line of credits.