We just finished the “Take this debt and SACK it” series where a four-step plan to get out of debt was outlined. Click here if you missed this series. At this point, we’re going to talk about preventing relapse into debt and preventing debt in the first place if you’re not already in it.
If you’ve just started making a concerted effort to get out of debt, congratulations to you! The freedom of having your salary go to you instead of the bank is well worth the effort. Hang in there! Now that you’re on your way, it’s important to establish new patterns to avoid going back into the same hole that you’re trying to dig yourself out of.
One way that people often slip back into debt is when large expenses come up that they have not planned for. The payment is due, and out comes the credit card again. How can we avoid this? Some expenses are a surprise, but many are not. They occur each year around the same time for about the same amount. Our task for this week is tallying up those expenses, and coming up with a plan to start paying for them over the course of the year instead of all at once.
For example, in our house, the expenses that we pay annually include:
- property taxes
- house insurance
- car insurance
- life insurance
- Christmas gifts
Each year, we estimate how much each expense is going to cost, total them up, and divide by 26 pay periods. Then, we set up an automatic transfer to go from our chequing account to our high interest savings account on the same day as a payroll deposit. We adjust to our spending to reflect the net amount being left in the chequing account each time. Then, when we go to book our vacation (hurray), or pay our property taxes (ugh), the money is there. We don’t need to scramble to come up with extra money that particular month.
What type of account should you use to save for annual expenses?
I would encourage you to separate the funds for annual expenses from your regular chequing account for two reasons. First, savings accounts usually give higher interest rates. Second, having it separate makes it less tempting to spend the money on things it was not set aside for. Do not choose an investment that is going to fluctuate in value. Choose a guaranteed, interest-bearing account.
Canadian readers, you could use a tax free savings account (TFSA) if you haven’t otherwise maxed it out. If you’ve got credit card debt, then chances are that you’ve got lots of unused room in your TFSA. If you’ve maxed out your TFSA and are still carrying a balance on your credit card, please leave me a comment as to why because 99.999% of the time, this is a terrible idea.
Every Canadian over the age of 18 has been accumulating $5,000 of room in a TFSA per year since 2009. So, if you have never made a contribution to a TFSA, you could contribute up to $20,000 today. If you have made contributions to your TFSA before, you can find out how much room you have available by calling Canada Revenue Agency at 1-800-959-8281. If you prefer, the details on how to work through the calculations can be found on the CRA web site at this link.
The advantage of using the TFSA is that the interest that you earn on the account is not going to be taxed. Unlike an RRSP, you do NOT get a tax deduction for putting the money in the account in the first place, but you also do NOT report the amounts you withdraw as income. The only down side to using a TFSA for frequent deposits/withdrawals is that the amount that you deposit into the account comes off of your TFSA room right away, but the withdrawals that you make don’t get added to your room until the following year. This could be an issue if you plan to deposit close to the contribution room that you have available. Otherwise, using the TFSA could be a good choice.
If you’re not eligible for a TFSA or have used it for another purpose, then a simple high interest savings account will work. If you are in a dual income family, the spouse with the lower income should be the one to make the contributions to the investment account. Even if the account is joint, if they are the one making the contribution, then they would be the one to claim the income on their tax return. If the lower income spouse claims the income as opposed to the higher income spouse, then less tax will be paid on that income. If you’re using a TFSA, then it doesn’t really matter whose account it’s going into because no tax will be paid on the interest anyway.
Setting it up
The bank that you currently deal with will likely have an option for the type of account that you choose. Many will allow you to open the account online. Once you have the account open, add up your annual expenses and then divide the total by the number of pay periods that you have in the year. Then, set up an automatic transfer from your chequing account to your savings account. Never scramble for yearly expenses again!