Emergency Funds and Tax-Free Savings Account

by Mike Holman

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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 inefficiencyinterest 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.

More information on the TFSA

Benefits of the Canadian tax free savings account

Tax Free Savings Account (TFSA) Basic information for Canadians

Comparison between Canadian TFSA and American Roth IRA

Tax Free Savings Account refresher for Canada

ING offers TFSA refresher for Canadians

Is the RRSP still worthwhile because of TFSA accounts?

Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund

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{ 2 comments… read them below or add one }

1 Mr. Cheap

TFSA is interesting, but everyone seems to be scratching their heads to come up with a good use for it. I think a savings account for a large purchase (and doubling as an emergency fund) is as good a use as any. If its there, you might as well use it, however its doesn’t seem RADICALLY better than using a LOC for emergencies, and just selling enough of your long term investments to pay for the vehicle (when the time comes). Or prepaying your mortgage, then buying the car with the larger resulting HELOC.

2 Four Pillars

Cheap – no, it isn’t much different. However, a lot of people like the psychological effect of having CASH so the TFSA will help them in a more tax-efficient manner.

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