Major expenses don’t always fit neatly into a traditional monthly budget. For example, buying Christmas gifts is likely the last thing on your mind in July. In fact, you may not think about it until December, at which point you’ll need to come up with enough money for many gifts at once.
Enter sinking funds – an innovative concept that will reshape how you think about budgeting throughout the year. Keep reading for an in-depth walkthrough, including a breakdown of sinking fund categories most adults need.
What is a sinking fund?
A sinking fund is simply a pool of money built up over time to cover a significant future expense. It dilutes the impact of that expense, spreading it out over a longer period.
While I’ll be discussing sinking funds in a personal finance context, it’s worth mentioning that large organizations (i.e. companies and governments) use them as well. For example, when corporations borrow money via bonds, they’ll often set up sinking funds to make repaying the debt less of a hassle when it comes due.
The same logic applies when using sinking funds in personal finance. Rather than having to come up with hundreds or thousands of dollars for Christmas gifts at once, for instance, you could simply set aside smaller amounts every month from January to November.
With a sinking fund, you’re essentially setting up a prepayment plan with yourself rather than putting those costs on credit at the last minute and having to make monthly payments (with interest).
How does a sinking fund differ from an emergency fund?
“But wait,” you might be thinking. “I already have an emergency fund! I shouldn’t need a sinking fund then, right?”
In reality, however, your emergency fund should be reserved for truly unforeseeable and dire circumstances. Most sinking fund categories fall outside this definition. The fact you could create a sinking fund for them means they are foreseeable and you should plan accordingly.
15 sinking fund categories you likely need in your budget
To demonstrate the usefulness of a sinking fund, let’s look at a few common categories people use when organizing their finances this way. After listing these categories, I’ll walk you through the steps and best practices for creating your sinking fund.
1. Christmas gifts
I’ve used this example many times so far because it’s truly a quintessential sinking fund category. According to a MagnifyMoney survey, roughly one-third of Americans took on debt during the 2020 holiday season. Among those Americans, the average debt balance was $1,381 and 89% said they wouldn’t be able to pay it off within a month. To make matters even worse, 18% of Americans with holiday credit card debt reported intending to make just minimum payments, incurring substantial interest charges.
This could easily be avoided with a sinking fund. If we divide $1,381 by 11 (the number of months that aren’t December), we arrive at $125. That’s how much money you’d need to set aside every month in a sinking fund to cover such a bill without taking on debt.
Most vehicle owners incur maintenance costs at some point throughout the year. Whether those costs are low (i.e. changing your tires, getting an oil change, etc) or high (i.e. fixing a catastrophic failure), a sinking fund can help you cover them without breaking a sweat.
Of course, the challenge is that (unlike with other sinking fund categories), you may not readily know exactly how much to allocate towards car maintenance. With a bit of research, though, you can likely arrive at a reasonable estimate. I’d recommend checking out this database from Edmunds to start. It contains data regarding ownership costs for just about every popular car brand imaginable.
Once you’ve arrived at an estimate, begin moving money into your sinking fund until you have enough for the year.
Many people go one step further and set up a sinking fund for their next vehicle purchase. That way, they’ll be able to pay cash or at least have a substantial down payment.
As with vehicles, most homeowners incur maintenance costs throughout the year. Experts (such as HomeZada co-founder Elizabeth Dodson quoted in this article from The Balance) estimate these annual costs at between 1% and 4% of a home’s value, depending on its age.
You could set up a sinking fund containing this amount and replenish it whenever you make withdrawals.
You might also want to budget for the following items in your homeownership cost sinking fund:
- property taxes
- utilities (if you pay quarterly)
- snow removal (if you pay someone for that)
4. Medical expenses
Even if you have medical insurance, trips to the doctor or hospital likely result in some cost (i.e. in the form of a deductible). You’ll likely find a sinking fund very helpful when planning for these expenses.
Depending on your country of residence, there may even be accounts designed specifically for health-related sinking funds. In the United States, for example, you can open a Health Savings Account and reap tax benefits while saving for qualifying medical expenses.
5. Self-employed taxes
When you’re self-employed (i.e. a freelancer), taxes usually aren’t withheld at the source. Consequently, you’ll need to pay taxes in lump sums every quarter or year.
I’m all too familiar with this, having previously worked as an independent contractor for several years. My tax bill every spring pushed well into the five-figure territory.
It would’ve been difficult to come up with that much money all at once if I’d spent or invested 100% of every paycheck elsewhere. Instead, I estimated how much of each paycheck would normally be withheld and transferred that money into a sinking fund. When tax season rolled around, I just tapped into that account to cover the bull.
If you’re currently in a great relationship that will likely lead to marriage at some yet-undetermined point, creating a wedding sinking fund may be a good idea.
After all, weddings can be quite expensive. According to The Knot, American weddings cost $19,000 on average in 2020, even amid a pandemic. In 2019, the average cost of a wedding was $28,000.
Meanwhile, the average time couples spend dating before getting married is between two and five years, according to Brides.com. If you and your spouse-to-be fall at the shorter end of that range, you’d need to set $14,000 aside in a sinking fund annually to cover the cost of an average pre-pandemic wedding. If you wait until the five-year mark, you’ll just need to save $5,600 annually.
Of course, you could get this number even lower by having a much cheaper wedding. Check out this article for a list of alternatives to traditional weddings.
Last year, I made the mistake of traveling without much of a sinking fund set aside for that purpose. Note: I initially did set enough money aside but threw it into the market during the March 2020 crash.
While everything worked out, I had to pull some financial acrobatics later in the year. It would’ve been much easier if I created a sinking fund during the first few months of the year and budgeted my travel accordingly. Learn from my mistakes!
8. Dining out
Dining out is another expense many people incur infrequently enough to warrant making it a permanent part of their budget. Rather than just lumping it in with “recreation” or some other broad category, create a sinking fund you can pull from whenever the urge to dine out strikes.
9. New furniture and appliances
Every few years, you’ll likely need to replace at least one significant appliance or piece of furniture. A dedicated sinking fund is a great place in which to do this. Set it and forget it!
10. Subscriptions that renew annually
You can often receive substantial discounts on software subscriptions by paying for an entire year at once. While that’s great, being caught off guard when that subscription renews certainly isn’t. Thankfully, you can avoid this by transferring enough money into a sinking fund every month to pay for the subscription renewal when it rolls around.
11. Childcare expenses
If you have children, consider setting up a sinking fund for costs such as:
- college tuition (look into tax-advantaged accounts designed specifically for this purpose)
- school supplies
- recreational activities (i.e. organized sports, camp, etc)
- clothes (remember, young kids grow out of clothes almost overnight)
This is among the most important sinking fund categories if you have young children. Remember, it’s your legal (and ethical) responsibility to take care of them. Don’t let your lack of planning be the reason they go without essentials.
12. Pet care expenses
According to The Spruce, caring for a dog costs (on average) between $1,500 and $9,900 annually. That includes irregular expenses such as:
- trips to the vet
- preventative treatments
Meanwhile, PetCoach pegs the average annual cost of caring for a cat at $809. While that makes them cheaper than dogs, it’s still enough money to warrant setting up a sinking fund.
13. Major discretionary personal purchases
If you plan on purchasing something significant to mark a particular milestone (i.e. a Rolex for your 50th birthday), create a sinking fund for it. This will help you avoid overextending yourself (which is a big no-no when it comes to discretionary purchases) when the time comes.
14. Charitable giving
Do you donate money at various points throughout the year (i.e. at Christmas or in honor of a deceased loved one on their birthday)? An associated sinking fund can ensure you have enough to give liberally at the desired time.
15. Miscellaneous recreational activities
This is among my favorite sinking fund categories because it lets me capitalize on spontaneous opportunities (i.e. grabbing dinner with an old friend who visited town unexpectedly) without blowing up my monthly budget.
If you’re saving towards something specific (i.e. a vacation), one of the other categories will likely suit you better. This one is for truly spontaneous fun.
The step-by-step process for creating sinking funds
Now that I’ve shared a few useful sinking fund categories, let’s walk through the process of setting up your series of funds.
Step 1: Identify your sinking fund categories
Start by listing the categories in which you’d like to set up a sinking fund. I’ve provided 15 options that should cover the most common scenarios but, of course, feel free to choose other categories if they suit your situation better.
Step 2: Open a dedicated account for each sinking fund category you’ve chosen
With so many no-fee online banking options these days, opening multiple accounts has become quite practical. That’s why I recommend opening a dedicated checking, savings, or money market account for each sinking fund category you chose in the previous step.
I’d recommend choosing a checking account if you’ll be withdrawing funds frequently, a savings account if you might but aren’t sure, and a money market account if you know your withdrawals will be infrequent.
Step 3: Calculate (or estimate) how much money needs to be in each sinking fund (and by when)
Next, figure out how much money you need in your sinking funds to comfortably cover the associated expenses when they arise. For example, if you’ve created a sinking fund for your next vacation, it should contain enough money to pay for the entire trip.
This number (and target date) will come in handy during the next step.
Step 4: Divide each target sinking fund balance by the number of months you have to build it
Now, figure out how much money you need to save each month in order to achieve your target balance for each sinking fund by the chosen date.
For example, if it’s May and you’re looking to accrue $1,381 by the start of December (seven months from now), you’d need to save roughly $200 per month.
Step 5: Set up automatic deposits to your sinkings funds
Lastly, consider setting up monthly (or biweekly) automated deposits to your sinking funds. This will be so much easier than having to constantly remember what accounts and amounts to transfer. Check out this article for some tips on automating your finances.
Sinking funds are incredibly useful. They’ll make your budget more resilient and help you plan for irregular expenses with greater ease. After implementing them, you’ll ideally never have to worry about scrounging for cash whenever a major predictable expense pops up.
I hope this article has helped you see how sinking funds might fit into your financial planning! Check out my other articles related to financial planning here.