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 $83,000 of combined contribution room in their TFSAs. They could start with this principle amount, and continue to contribute $11,000 per year to build a diversified portfolio of high quality stocks, real estate, and fixed income assets. After 30 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 5% 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
Hey great advice! And a very useful graphic. I noticed your > symbol is backwards for low interest debt.
Nice catch Mr. Moose. 🙂 You have a great eye for detail. I’ve gone and switched the symbol.
Given the gloomy forecasts of expected market returns for the next 10-25 years (see Bogle, Swendroe, Bernstein, etc), I would re-define high-interest debt as anything with interest > 4% instead of the 6% you mention.
Great point, Giselda. 🙂 With interest rates expected to stay low for quite awhile longer it’s difficult for income investors to produce any yield on their investments without being forced into higher risk assets. I have redefined the high interest debt to have a rate above 5%, which is probably closer to reality than what I initially posted. I think many people will just decide on what their own personal expected rate of return will be over the long run and reconcile that with how much interest they are paying on their debts. Thanks for the feedback.
Depends on income level as well. 401k should come before Traditional IRA if phased out of pre-tax contributions for IRA due to income limits.
That makes sense. 🙂 I’m no retirement expert, but these things do depend on which income bracket you’re currently in and what your expected income will be when you eventually retire. The best thing to do is just max out everything, lol, if you can afford to that is.
Agree!!! MAX Everything and learn how to live within that budget that is left over. I would highly recommend this to anyone starting out and for the first 5 years… After you have built up a nice starter retirement fund, I think you can back things off a little if you need some to support family.. Be on the look out for a bear market or market down turn and take advantage of that by increasing contributions during that time as much as possible. It will happen just a matter of when…
The RRSP math is tricky. You are cashing in now with the return but you are also creating a tax timebomb.
One stupid mistake I made when I started working (low wage, low tax rate) was puting a lot of money in my RRSP. I will pay a higher rate I get the money out.
It can get even worst when you have an employer pension. My parents are now forced to draw from their RRSP because of their age and that is pushing their income in the CPP clawback range.
Thank goodness we have the TFSA now. It’s more difficult to save money for retirement with just RRSP alone, and like you mentioned, sometimes it’s better to not even use the RRSP if you’re not earning a lot of money right now.
I’d say any type of employer matched savings is top priority. Seems like most match at least 50% of your own contributions, and that 50% return beats any kind expensive debt
I agree. It’s basically free money. 🙂
[…] Where to put your extra savings by Freedom Thirty Five Blog – great infographic on how to prioritize your savings and investments for both Canadians and US folks […]
Very interesting post. I’m glad to have the Canadian perspective. I’m still trying to figure out how any working person with a family and a house and a car or two can maximize their RRSP or RESP 🙂
It wouldn’t be easy unless the household income is very high. Of course if the grandparents are willing to help contribute to the RESP then that would help.
Glad you like the post. 🙂
[…] Priorities – Savings vs Debt Repayment […]
Is the TFSA statement still valid in 2018; I believe the yearly amount be 11,000, and not $20,000. Would this change how you would prioritize the TFSA?
Good point. The rules have been changed since 2016. I have updated the post with $11,000 per year as the maximum amount each year a couple can contribute.
[…] Priorities – Savings vs Debt Repayment […]
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