Everyone should have a rainy day fund in case of an emergency. Having money set aside for a financial disaster will give you peace of mind, not to mention the ability to deal with whatever problem arises.
If you’re going to have a rainy day fund, the question then becomes where it should be kept. For three reasons we’ll discuss, a tax-free savings account (TFSA) makes an ideal place to park money for a financial emergency. (Unsure of what a TFSA is? Read our primer: What is a TFSA?)
You can withdraw money without paying tax
Unlike an RRSP, money can be withdrawn at any point from your TFSA without any tax consequences. With an RRSP, any money withdrawn is counted as income unless it’s used for the Home Buyers’ Plan (HBP) or Lifelong Learning Plan (LLP). However, because TFSAs are funded with after-tax money, you can take money out and it won’t be taxed. The only caveat is that you must wait until the following year to re-deposit the withdrawn amount back into the TFSA if you’ve maxed out your contribution room.
Generous contribution limit
Every year, the government allows Canadians over the age of 18 (or 19 in some provinces and territories) to contribute a certain amount of money to their TFSA. The 2017 TFSA contribution limit is $5,500. Importantly, if you didn’t maximize your contributions in prior years it carries forward. As of this year, a Canadians who were 18 or older in 2009 (the year TFSAs were introduced) may have up to $52,000 in TFSA contribution room.
Due to this large amount of contribution room available, TFSAs are an ideal way to put money aside for a rainy day (among other purposes, such as general saving). If you have a large expense that requires a substantial amount of money quickly, dipping into your TFSA may be the most feasible route.
Many investment options
A TFSA is more than just a savings account. There are many different kinds of investments you can hold in your TFSA. Here’s a list of some of the more popular ones:
- Mutual/index funds
- Exchange-traded funds (ETFs)
- Cash (look for the best TFSA savings accounts)
- GICs (check out the best GIC rates)
Depending on your personal level of investment knowledge and risk tolerance, you’ll probably want to have a balanced TFSA consisting of various types of investments. Naturally, there tends to be a relationship with risk and reward in investments, having a diversified mix is important. Stocks, for example, tend to outperform in the long run, but can be volatile and occasionally suffer sharp drawdowns. GICs and high-interest savings accounts, on the other hand, come with security of principal but have comparably lower returns as a result.
The bottom line
If you think you’ll be using your TFSA primarily as a rainy day fund, that should affect how you construct your portfolio. In other words, if you’re relying on the TFSA to get you through a financial emergency, you probably don’t want to have risky or illiquid investments. The problem with risky investments is the value of your rainy day fund could decline significantly, leaving you in a bind. But it’s also important that you be able to quickly cash out of any investments if you need money quickly. For this reason, you probably shouldn’t put all of your money in non-redeemable GICs.