A few weeks ago, a tidbit from Home Economics No. 44 caught my attention. In the Savings section, the writer noted:
I started creating “sinking funds” several years ago—I’m not sure where I first heard about it; probably on Instagram. I’ve found it useful in helping me save for bigger and recurring expenses.
- Travel: $250 (I recently spent a lot from this account. I contribute $320 each month.)
- Gifts: $175 (contribute $40 each month)
- 40th birthday party: $2,700 (contribute $150 each month)
- Yearly expenses: $550 (contribute $200 each month)
- Car expenses: $1,600 (contribute $135 each month)
Having a sinking fund for a big, fun party, in particular, resonated with me, and other readers liked the idea, too. “I love the sentiment on saving up for a big 40th birthday party as someone who isn't planning on getting married or having kids—need more reasons to celebrate things like this besides weddings and babies,” wrote one commenter.
So let’s talk about the benefits of sinking funds. If you’re not familiar with the term, they are designated savings accounts for specific items or events that you plan to spend down in the future. The goal is to make saving for a big expense easier by spreading it out over a few months or even years.
You can set up a sinking fund for basically any type of savings goal, both practical or otherwise. Single in Boston has one for her 40th birthday party as well as for car expenses. Other popular goals include vacations, home renovations, weddings, and back-to-school shopping. I have one for future baby expenses and one for a handbag, if I ever actually go on my honeymoon to Italy.
When you have a big annual expense or two—say property taxes or summer camp fees—setting up a sinking fund and contributing to it over time can help ensure that you’re not scrambling to come up with the money to pay for it or relying on a credit card with a high interest rate.
Say your goal is $10,000 for your 40th birthday party in five years. You can aim to set aside $167 a month, making it much more of a manageable goal. Or if you know you need $6,000 for your property taxes, you can earmark $500 each month.
By establishing a separate account for your goal, you’re able to gamify saving for it, and when you finally reach your goal, you’re able to spend the money guilt-free.
A sinking fund can give you a sense of security and freedom in knowing that you set aside the money for a specific goal, says Laura Combs, certified financial planner at Mercer Advisors. “It actually takes the stress of that 40th birthday or Christmas or holiday gifts off of [your] plate.”
One of the primary benefits is psychological, says Combs. Of course you could keep any and all savings in one account, but the point of a sinking fund is to sooner or later spend the money on a preplanned expense—not an emergency or unexpected cost.
By keeping the funds in a separate account, you’re delineating your emergency fund—which you really don’t want to touch unless, well, you’re dealing with an emergency—from other goals physically and mentally.
Where to keep it
Most people keep these accounts as actual savings accounts at a bank or other financial institution. If you go that route, make sure it’s in a high-yield account so you can also earn interest. I keep most of mine at the same bank, but some people like to open them at a bank not connected to their daily financial activity to add a little friction to the savings process. This is the best course of action if you’re planning to spend the money within the next 12 to 24 months.
But that’s not the only option. Let’s take the wedding fund. Say you decide to establish one for your young child, so you presumably have quite a few years until he or she will need it. You could keep any cash in a high-yield savings account no problem, or you could invest it with the goal of giving your savings a boost over the ensuing years.
You have a few options. A short- or long-term CD is a safe option, while investing it in, say, an index fund or bond fund in a brokerage account is a little riskier but might yield a higher return in the long term. You just don’t want to invest money you plan to spend for near-term goals in a retirement account, like an IRA, because there are fees and penalties associated with early withdrawals.
“My husband and I are thinking about a 20-year wedding anniversary. We have several years to save for that, we don't need that money immediately,” says Combs. “It could get some growth in the stock market, knowing that we are assuming that risk.”
The order of operations
If you’re wondering where a sinking fund (or two) fits into your overall financial picture, Combs advises prioritizing the following order of operations for your savings:
- Emergency fund of 6 to 12 months’ worth of expenses
- Necessary annual sinking funds (think: insurance premiums, property taxes, child care)
- Retirement and other long-term savings
- Sinking funds for specific “fun” goals
“I’m a huge, huge advocate for the emergency fund first, and then the fun stuff,” says Combs. “Get the foundation in order, and then build upon that for the fun and exciting stuff.”
