3 thoughts on establishing your emergency fund

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For a long time, we didn’t have an emergency fund, though we’ve had a line of credit (LOC) for quite a while.

Our household budget was within our means. We were operating fine in our regular spending routine without having to check when payday was coming. There was also a fair amount of reserve that had built up in the separate accounts we’d established for each of the major expenses.

It wasn’t for fear of holding money in no/low-interest cash that might otherwise be making investment income. No, that’s exactly the effect of those individual accounts anyway. Rather, we were confident in the arithmetic, and didn’t think there was a need to have that one account.

It wasn’t until we had to dip into one of those reserves to replace an appliance that our perspective shifted: Large though that reserve had become, it had a defined purpose and calculated amount that would eventually deplete it. Emergencies aren’t like that.

1. The why of an emergency fund

An emergency fund isn’t about being budget-conscious; it’s about potentially being UNconscious, indisposed and/or impecunious at a time when there remains a budget to be serviced. It’s about you and your ability to be the continuing funding source for your household.

It’s also about being able to respond to large, unexpected expenses. Be careful though not to confuse that with the major expense reserves mentioned above. Years will pass before those needs may arise, but while the exact timing may be unexpected, those remain inevitable.

At the other extreme from normal budgeting are unlikely things such as catastrophic property damage, permanent disability or death. Insurance is for those remote-risk/high-peril events. Between those two is where an emergency fund is situated.

2. LOC or emergency fund – What’s your gut feel?

Part of my own early confidence lay in the fact that as the mortgage was being knocked down, we’d set up a substantial line of credit. It was more than sufficient for the 3 months – or even 6 or 12 months – worth of accessible funds variously suggested to bridge until things would be expected to normalize after an emergency might hit.

But over time I became more familiar with my own emotional relationship with money. Ever since I had a mortgage … I didn’t want one anymore. Though we lived contently and made appropriate allocations to retirement and children’s education savings, the extra dollars were put toward trimming that large liability. That was the mindset and routine while in the midst of stable finance and balanced emotion.

So, how might I feel in a future time of monetary and mental stress, being compelled to dive deeper into debt? Not good in all likelihood. In fact, that prospect could easily exacerbate the impact of any emergency that may in fact arise, and extend out the recovery time. For us, that was when the formal emergency fund took shape, while maintaining the line of credit as the next line of defence.

That’s our family, not necessarily yours. Still, you would do your future-self a great favour by taking the time while things are rosy to contemplate how you will feel when things are not.

3. Deciding your __ months of money?

Assuming you’re committed to the purpose, the first action question to address is how much will you accumulate in that fund? The commonly suggested proxy is, as mentioned above, a certain number of months’ worth of accessible funds. But how many for you: 3, 6, 12, more?

As the timing and extent of an emergency is unknown, there is no formula to provide you with a definitive number. A practical approach is to focus on the most likely of those unlikely events: an employment gap, whether of your own choice or initiated by your employer. Knowing yourself and the industry where you work, how long do you think it would take to get re-situated? Other factors will come into play, like severance pay and employment insurance, but start here as a rough target.

Second, be clear about what this number of months means. In theory it is lost income, but more importantly in an emergency situation, it is the amount of spending that has to be replaced. The two are connected, but the latter continues even in the absence of the former.

Fortunately, unless you’ve been living excessively, your spending will be less than your earnings. Look back at your bank and credit statements over the last year. Take out the truly extraordinary things, and deduct items you can suspend or defer, at least in the short term. This is the monthly average to multiply by your chosen number of months to give you a target.

Third, how much will you regularly deposit into your emergency fund? By “regularly”, I mean weekly or in alignment with your pay cycle, which brings us back to your budgeting. As remote as an emergency may be, you need to assign a percentage or dollar amount that you can commit to, even if that’s a small figure.

Here then is another gut check: Divide your accumulation target by your weekly deposit commitment to tell you how long it will take to get there. If you’re feeling a knot forming in your abdomen, you may want to bump your commitment. Balance that against the discomfort of the current budgetary sacrifice to arrive at a manageable medium.

With a line of credit at your back along the way, you now have a process, timeline and dollar target to get your own emergency fund in place.

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

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There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.

5undamentals – RDSP – Registered Disability Savings Plan

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Discuss these 5 fundamentals with your advisor to learn how they apply to you, and whether there are further details, qualifications or exceptions to consider.

1. What is a Registered Disability Savings Plan (RDSP)?

Purpose – The RDSP is a long-term savings plan for persons with disabilities and their families. It offers 3 main financial benefits: 1) Government money added to your contributions 2) Tax-sheltered growth of all money in the plan, and 3) Tax eventually borne by the plan beneficiary, not contributors.

Qualifying criteria –

  • Disability tax credit (DTC) – Application for the DTC is made by or on behalf of an individual using CRA Form T2201. A medical professional must certify that the applicant has a severe and prolonged impairment, providing details of its nature and describing the effects on the person.
  • Age limit – A plan may be opened any time before the end of the year the person turns 59, and may remain open for the life of the beneficiary, though some events may cause earlier closure.
  • Canadian resident – The beneficiary must be a Canadian resident when the plan is opened and when any contribution is made. A holder (who is not the beneficiary) need not be a Canadian resident to open a plan, but both holder and beneficiary must have a valid social insurance number at that time.

Effect on other public support –

  • Federal – Neither RDSP assets nor RDSP withdrawals affect eligibility for federal programs such as the Canada Child Benefit, the G/HST credit, Old Age Security or Employment Insurance.
  • Provinces & territories – RDSP assets are exempt in determining eligibility for social support programs for persons with disabilities. Similarly, RDSP withdrawals are not generally treated as income that affects the amount of support from such programs, though some jurisdictions have a maximum RDSP withdrawal threshold, beyond which benefits may be reduced.
2. Parties to the arrangement

Parties – The holder enters into a contract with an issuer to save for the future of a beneficiary.

Beneficiary – There can be only be one RDSP for a given beneficiary, and only one beneficiary for each RDSP. Once personal funds are contributed into a RDSP, they belong to the beneficiary, not the holder. Government assistance and earnings also accrue to the beneficiary, but may sometimes be repayable.

Holder – The holder opens the RDSP, names a beneficiary, and makes decisions on the plan, including whether to allow others to contribute. As to who may be a holder, it depends on the age and contractual competency of the beneficiary.

  • Minor beneficiary – A parent, or a ‘legal representative’, being a guardian, curator or agency authorized by provincial/territorial law. Age of majority is either 18 or 19, by province/territory.
  • Adult beneficiary who is contractually competent – The beneficiary.
  • Adult beneficiary who is NOT contractually competent – A legal representative.
  • Adult beneficiary whose contractual competence is uncertain – A qualifying family member (QFM), generally being a parent, spouse or common law partner (CLP).

Issuer – Financial institution offering RDSP based on a specimen plan submitted and approved by Canada Revenue Agency (CRA); certifies accuracy of applicant information; administers contributions, rollovers and transfers; applies for, receives and deposits CDSG & CDSB; invests funds as directed by holder; provides statement of accounts; makes payments from RDSP to eligible beneficiaries; and is ultimately responsible for maintaining tax-registered status.

3. Contributions and tax treatment

Contribution limits –

  • Lifetime limit – The lifetime contribution limit is $200,000.
  • Annual limit – There is no annual limit, but there are annual limits to the amount of government assistance that may be received (see below), which could influence your contribution timing.

Qualified investments – RDSPs may generally invest in the same kinds of deposits and marketable securities allowed for RRSPs and other registered plans.

Tax treatment –

  • Coming in – RDSP contributions are after-tax, meaning there is no tax deduction for placing funds into a plan. Government assistance is not taxable when credited to a plan.
  • Within – While in the plan, there is no tax on income or growth, whether on your contributions or on any government assistance.
  • Coming out – When taken out, all income and government assistance are taxable to the plan beneficiary. The later withdrawal of the portion that is your own contributions is not taxable.

Rollover contributions – Under qualifying conditions, funds held in education and retirement savings plans may roll tax-deferred into a RDSP. These rollover amounts count toward the $200,000 lifetime contribution limit, but do not attract CDSG and will be taxable on withdrawal.

  • Registered education savings plan (RESP) – One of three criteria must be met, two dealing with plans that have been in place for many years or decades, and the third applying where the beneficiary cannot attend post-secondary school for DTC related reasons. In all cases, only an otherwise accumulated income payment (AIP) of the RESP earnings may be rolled over.
  • RRSP, RRIF, RPP, PRPP, SPP – These plan types may be rolled over from a parent/grandparent on whom the beneficiary was financially dependent at the time of the former’s death.
4. Government assistance

Family income – Amount of assistance depends on family income. Up to the calendar year when the beneficiary turns 18, it is the family income of the beneficiary’s primary caregiver. Starting the calendar year the beneficiary turns 19, it is the beneficiary’s own family income, which includes the income of a spouse/CLP. [The following income figures are for 2020 entitlements, based on 2019 family income.]

Canada Disability Savings Bond (CDSB) – The CDSB makes an annual payment to a RDSP, regardless of personal contributions. Up to family income of $31,711 it is $1,000, which is then phased-out to zero when family income reaches $48,535. The lifetime bond limit is $20,000.

Canada Disability Savings Grants (CDSG) – The CDSG matches personal contributions at a 1:1, 2:1 or 3:1 rate. If family income is below $97,069, the matching rate is 300% of the first $500 in contributions and 200% of the next $1,000 in contributions. If family income is above this threshold, the rate is 100% of the first $1,000 in contributions. That’s as much as $3,500 in one year, with a lifetime limit of $70,000.

Carryforward and usage timeline – You can carry forward up to 10 years of unused grant and bond entitlements to claim in future years, as long as you meet eligibility requirements in those future years. The annual usage maximum for carried forward CDSG is $10,500, and $11,000 for CDSB. All grants and bonds must be claimed by the end of the year the beneficiary turns 49.

10-year repayment rule – Grant and bond money received in the preceding 10 years may have be returned to the government upon certain events. These include intentional termination of the plan, ceasing to qualify for the DTC, and death of the beneficiary. Consult your issuer to explain all triggering events, and the availability of relief and/or deferral depending on the circumstances.

Provincial assistance – Provinces may also enact programs to assist RDSPs and their beneficiaries.

5. Payments out of the plan

Three payment types – Funds come out of a RDSP by either: 1) Repayment of CDSB, CDSG or provincial support to the respective government 2) Transfer/payment of the holdings to a RDSP for the same beneficiary with another issuer 3) Assistance payment to the beneficiary. Our focus is on the last of these, assistance payments.

Assistance payments – The regulations on drawing funds out of a RDSP are complex, with there being two types of payments to a beneficiary – DAP and LDAP – governed by a variety of rules as to the amount, timing and composition of those payments.

  • Disability assistance payment (DAP) – A DAP is a RDSP withdrawal at the holder’s request, as made from time to time, payable to the beneficiary or their estate.
  • Lifetime disability assistance payment (LDAP) – A LDAP is a recurring annual (or more frequent) RDSP withdrawal paid to the beneficiary. Once begun, the LDAP series must continue until the beneficiary is deceased or the funds in the plan are exhausted.
  • Composition of DAP or LDAP – Each payment is a proportion of each of personal contributions, earnings, CDSB, CDSG and provincial support. The beneficiary/recipient of the payment is taxed on all components, except for the non-taxable return of personal contributions. The beneficiary does not have to be a Canadian resident to receive a DAP or LDAP.
  • Minimums and maximums – The allowable amount for a DAP or LDAP depends on many variables, including 1) Age, specifically 59-under or 60-plus 2) Whether government support exceeds personal contributions 3) CDSB & CDSG receipts in the preceding decade 4) If the beneficiary’s life expectancy is less than 5 years, and 5) Formulas prescribed by regulations.

Death of beneficiary – Upon the beneficiary’s death, all CDSB, CDSG and provincial support paid in the preceding 10 years must be repaid to the respective government. It is not possible for a RDSP beneficiary to directly name a beneficiary to receive the plan upon his/her death, so the remaining RDSP assets will be a taxable receipt for the beneficiary’s estate, except the non-taxable return of personal contributions. The plan must then be closed no later than December 31 of the calendar year following the year of death.