What Is a Sinking Fund and How to Set Up One?
Trying to navigate the jargon of the personal finance realm becomes increasingly difficult when so many terms are closely related yet different. One area that often creates confusion is a sinking fund. What are sinking funds? How much do you need in a sinking fund? Why do I need a sinking fund? Logistically, how do I create a sinking fund? How is a sinking fund different from an emergency savings account? At Your Money Line, our goal is to help your employees navigate this space (and others). Learn more about our team and how we answer questions like these for employees.
What is a sinking fund?
A sinking fund is an account established for a specific purpose that may or may not have a set budget. Ideas can include saving for all kinds of life’s emergencies. Categories can include but are not limited to the following:
Emergency vet bills, annual vaccines, and preventative medicines add up. It’s often the most cost-effective to purchase preventatives at a vet appointment, so this yearly expense can quickly become a budget buster. Enter, sinking funds.
- House maintenance
A new roof, a window package, or even a new hot water heater – these expenses aren’t frequent but can be hefty.
- Child/dependent expenses
Medical expenses before hitting your annual deductible, back-to-school supplies, the list is seemingly endless.
Why do you need a sinking fund?
We’re often asked at Your Money Line:
“What is a sinking fund used for?”
“What is the purpose of a sinking fund?”
In short, sinking funds are used to reduce the volatility of life’s financial emergencies.
You need a sinking fund because the unpredictability of life is often expensive. A sinking fund can help soften the blows of broken hot water heaters, emergency vet bills, or the holiday season. If you save consistently for these infrequent expenses, you won’t feel the pain of the expense as it occurs as you’ve been planning for it all along.
There are several benefits to sinking funds:
- There is less volatility in the month to month
Saving consistently for emergencies reduces their impact when they occur. If you’ve been socking away cash every month when your hot water heater goes out, you can use the cushion vs. trying to adjust your monthly budget.
- Decreased volatility yields greater success
The less fluctuation, the greater the consistency, and the greater your chance of success
- Greater organization
One of the keys to maintaining your financial health is to get (and stay) organized. Sinking funds will help achieve this organization.
Sinking fund vs. Savings account
“Every square is a rectangle, but not every rectangle is a square.”
I believe I learned this in geometry. (or perhaps it was algebra?). Either way, this logic path applies to sinking funds as well. Every sinking fund is a savings account but not every savings account is a sinking fund. Due to the time horizon, you won’t want to place your dollars anywhere but in a liquid account (like a savings account). A sinking fund might differ from a savings account because you might make frequent withdrawals.
Sinking fund vs. Emergency fund
A sinking fund is very closely related to an emergency fund. There are some slight differences between these types of accounts. Your sinking fund should receive regular contributions. In fact, this is true for both a sinking fund and a savings account. In addition, the dollars in both your sinking fund and your emergency fund should not be taking risk (with respect to investing) as you might need to use these dollars with little to no warning. After all, emergencies aren’t predictable. The primary difference between a sinking fund and emergency fund is that a sinking fund is for a specific emergency. An emergency fund is intended to be used primarily for a reduction or loss of income.
How to set up a sinking fund
Setting up sinking funds can feel overwhelming if this isn’t something you have done before. The great news is that the financial guide team at Your Money Line is prepared to help employees walk through these steps to establishment.
Step 1: Determine the goal for your sinking fund
Will you save for a possible pet-related emergency? Do you want to cash flow housing expenses? Before you start you need to decide what you’re saving these funds for. There are no restrictions or right or wrong answers here. Maybe you like to update your decor frequently, you like to collect specific items, or maybe you like to update your wardrobe. As long as we’re planning for what’s important to you, it doesn’t matter what category you choose. Without a goal for the dollars, we can’t set a goal contribution for the account, which is the next step.
Step 2: Decide how much you would like to maintain in the account
Before establishing a savings frequency, we need to know what dollar amount we’re aiming for in the account. You could have an idea of how much you are comfortable contributing. It might be helpful to comb through old expenses to see how much you’ve spent on the category in the past. If possible, I would recommend looking back at a year’s worth of expenses. Certain categories might fluctuate seasonally and a calendar year review can help ensure your goal amount is appropriate for your situation.
Step 3: Identify your account location
As discussed, you want to keep these funds safe and semi-liquid. These dollars shouldn’t be taking any risk as we anticipate withdrawing from these accounts on a regular basis. A savings account or even a checking account is probably the best location for setting up sinking funds. However, you could look into money market accounts as long as they’re guaranteed and there aren’t restrictions on the frequency of withdrawals.
Step 4: Establish your savings frequency
Once you know how much you want to keep in the account and where you’ll place the funds you can begin to fund the account. You’ll simply divide the goal amount of saving the by frequency of your paycheck. This amount will determine how much you need to save per check to fund the account. I would also recommend having these contributions be automatic. As discussed above, the more we can automate, the more consistent we become, and the greater our chance(s) of success.
Step 5: Repeat the previous steps as necessary
The purpose is to use the funds in the account on a semi-regular basis. It’s important to review (maybe quarterly at first) to ensure your plan for funding is working for you and your financial health.
How many sinking funds should you have?
“The limit does not exist.”
Ok, maybe the number of sinking funds you should have is not truly limitless. However, you should have as many sinking funds as you need. If you’re looking for a ballpark number it’s common to have 2-4 sinking funds. Again, don’t get too caught up in this number as personal finance is just that, personal. Depending on your stage of life you might need to establish a new sinking fund or two. As you move into your next phase of life you might need to eliminate a fund or two. It’s important to be flexible as your needs and goals change.
Expanding your family might present a need for new sinking funds. A sinking fund for medical expenses for a higher deductible, for back-to-school expenses, or for a more expensive holiday season. Moving to a new house/apartment might warrant a new fund for furniture or fixtures. Adding a new furry friend means preparing for vet bills.
It’s worth noting that having several different accounts isn’t for everyone. If you’re the type of budgeter who maintains just one account and then tracks via a spreadsheet or app, this is perfectly fine! You just need to know which method is best for you and your personality.
Trying to decide what sinking funds to establish, where to place the funds, and how to maintain these accounts is a lot to ask. Our Financial Guides work through these issues and several others with organizations just like yours on a regular basis. Your Money Line is here to increase your investment in your greatest asset, your employees. To learn more about how we’re here to help, how we serve your best asset, and to demo our product visit our contact page.