Establishing a sinking fund means setting money aside now because you know you'll need it—or want it—later. You should be able to avoid most financial emergencies and save your emergency fund for something along the lines of illness or job loss. Your emergency fund should be reserved for something that comes at you out of the blue, something unexpected, while a sinking fund is for a planned expense, something expected.
How to Set Up a Sinking Fund
Dedicate an account to hold your sinking fund. It can be a run-of-the-mill savings account, nothing fancy, just a way to segregate the money. Naming it accordingly can help keep you motivated and avoid dipping into it for other things. Give it a tag like "Beth's New Kitchen" or "Bermuda or Bust!"
If discipline isn't your strong suit, keep reminding yourself how happy you'll be when you've reached your savings goal. Imagine having or doing whatever it is you've been saving for whenever you're tempted to dip into the money for other things.
Now put a reasonable price tag on the expenditure. It can be tempting to go light, but then you might reach the finish line only to realize that you didn't save enough. Go too heavy and you might struggle and grow demoralized before you reach your goal. So research that kitchen or your Bermuda accommodations and set a realistic target.
Let's say your number is $6,000. Look at your budget. How much can you squeeze out a month? Something in the neighborhood of $500 will have you gourmet-cooking in your new kitchen in a year. It might sound like a long time, but look at it this way: You won't be going into debt to afford the remodel so you'll enjoy all that food a lot more without the added indigestion.
In some cases, you might already have a target date. Maybe that Bermuda trip is going to happen because your sister is having a destination wedding in 10 months. You'll have to up that $500 to $600 to make the nut, but you'll still be able to spare your credit cards a lot of heavy-duty lifting even if you can't manage that much. Saving even $200 a month means you won't have to charge as much.
Sinking Funds Can Be Precautionary
Sooner or later, you're probably going to have to tweak the exhaust system on your old car or call the plumber for a hopelessly clogged drain. Putting a little money aside each month now will make stressful events easier to manage. You're prepared.
Many people set aside money each month to cover these expenses without even realizing that they're technically sinking funds. And if you know you have a major repair coming up, you can determine how much you'll need to set aside to cover it in time.
Save for the Fun Stuff
Yes, we're back to Bermuda again. Set money aside to cover the cost if there's a dream vacation you're dying to go on, or even if you just want a chance to go to the beach this summer. Nothing ruins a vacation or a day off faster than knowing you really can't afford to be there. Your vacation shouldn't ruin your budget, and saving in advance is the best way to avoid that.
Keep in mind that it might take you a few years to save up if you're on a tight budget, especially if you have grand plans.
Cover Medical Expenses
You might already have a sinking fund of sorts with your health savings account if you have a high deductible health insurance plan. You should be able to handle the rest of your medical expenses without too much trouble if you can save up enough to cover your annual deductible.
You should also take into account any money that your employer will contribute to help cover your costs.
Consider how much you'll have to increase this type of sinking fund as you get married and have children. The amount should increase as your risks increase.
Plan for Major Purchases
Pay for major purchases with cash. You might start a sinking fund for the next car you want to purchase or save up for a down payment on a home. Establishing a sinking fund will help you to avoid going into debt and make it easier to purchase something you can truly afford. The more cash you have to put down, the less you'll have to finance.
The Bottom Line
Setting your sinking funds now will make it easier for you to reach your other savings goals and reduce financial stress. Track the money in a separate category in your budget. Treat it like a commitment and stay motivated as you watch the balance grow.