Where to put your extra savings
Let’s say you earn $3,000 a month and spend $2,500. Great! You are living within your means. But saving is only half the battle. Now you must decide how to allocate your extra $500. Should you pay down your debt or invest and watch your money grow? Should you max out your Tax Free Savings Account or contribute to your RRSP? Knowing the proper way to allocate your money can prevent a lot of costly mistakes.
Back when I was saving up for a car I guess you could say I had a lot of driving ambition. But sometimes there are more immediate and pressing concerns to address before spending money on wants and non-essentials. Below is a chart that shows where to put your savings in descending order starting from most important priority. It’s not perfect but it’s a relevant starting point for most people. 🙂
Notes on prioritizing savings:
- There’s no good rule of thumb to follow for how much someone should have in an emergency fund. A school teacher who has tenure and is not the primary breadwinner in the family may feel comfortable with only three months of expenses in a liquid savings account. But a self-employed, seasonal construction worker who earns irregular income may need nine months of expenses saved up to feel the same level of financial security. The right amount of savings in an emergency fund is whatever you feel is adequate, which depends on your personal affinity towards money.
- The chart only shows how to best allocate savings based on financial priorities. But it’s also important to understand how to optimize tax liabilities in different investment accounts.
- It’s essential to be properly insured. In the U.S. it might be useful for some people who have extra savings to expand their health insurance plan to add protection against a broader range of health risks. Canada has a fairly generous social safety net but it’s still prudent to have a look at critical illness and disability insurance coverage. If you’re not properly insured you could consider prioritizing adequate insurance right below pay off high interest debts.
- For Canadians who have kids I would add an RESP to the list and prioritize it right above the TFSA. The government will match (up to $500) 20% of what you contribute. It’s a guaranteed 20% instant return on investment. The U.S. has a similar tax-advantaged account called the 403(b) plan.
- For some high income earners in Canada contributing to their RRSP may be more appealing than using the TFSA. But I’m giving the TFSA a higher priority in the list because I believe it’s the better long term vehicle for most people. By the beginning of 2016 a Canadian couple would have $102,000 of combined contribution room in their TFSAs. They could start with this principle amount, and continue to contribute $20,000 per year to build a diversified portfolio of high quality stocks, real estate, and fixed income assets. After 25 years they will have a total investment portfolio worth over $1,000,000 in today’s constant dollars. That’s a comfortable tax-free cushion to fall back on. This calculation assumes a conservative 4% annual rate of return above inflation, which is not unreasonable to expect.
- The information in this post is simply a general guideline based on common values and priorities. Where to put extra money is a personal decision. Your list of savings priority may look different.
Random Useless Fact