Whether you’re getting a large raise or a small cost-of-living increase, receiving a bump in pay is always positive news. A bigger salary can help you live a more comfortable lifestyle and plan for the future.
Before you start spending your extra income at the club or online shopping, you need to make sure you’re allocating your funds wisely. Extra pay shouldn’t just sit in your bank account or go entirely toward frivolous purchases — you should make it work for you.
“If you know you’re going to receive a raise, then you should do your best to create a plan for what you’re going to do with the extra money before it ever hits your bank account. If you’re not intentional about what you’re going to do, then you’ll probably end up just spending the raise and contributing to lifestyle creep,” said Drew Feutz, certified financial planner at Market Street Wealth Management Advisors.
Here’s what to do when you get a raise.
1. Update your monthly budget
If you already have a monthly budget, you should update it to include your raise. Plugging your new income into your budget will show you how much extra money you have to play with, and help you allocate the funds accordingly (you may need to put in estimates at first and adjust the numbers after you receive your first paycheck).
While you may have some wiggle room for recreational spending, you should focus on important financial goals such as retirement or emergency savings first (more on that below). Allocate your additional income to the areas of your budget you wish to prioritize.
“While there’s nothing wrong with spending extra money that you take home each month because of a raise if your personal financial situation calls for it, many people may be able to identify more beneficial uses for those funds,” said Feutz.
If you don’t already have a budget, it may be time to create one. You can use our simple budget spreadsheet to get started.
2. Increase your retirement contributions
When you receive a raise, it’s a good long-term strategy to allocate a portion of it to your retirement contributions. If you increase your retirement savings using your pay raise, you won’t miss it as much as you would if you had maintained the same salary.
If you participate in a 401(k), it’s easy to adjust your contributions with your plan administrator. You can set a new contribution percentage and let the funds automatically come out of your paycheck. It’s an easy way to invest in the future without having to think about it too much.
Even a small increase in your monthly contributions can drastically increase the amount of retirement savings you’ll have in the long run. If you receive a 3% pay increase, for example, increasing your contributions by a single percentage point will boost your savings and still leave you with a nice 2% bump in your take-home pay.
If you aren’t already saving for retirement, getting a raise is the perfect opportunity to start. If your employer matches 401(k) contributions up to a certain point, you should take advantage. This is literally free money you can use to set yourself up in retirement. Don’t forget to look at other retirement vehicles, like individual retirement accounts.
In 2020, the contribution limit for 401(k), 403(b) and most 457 plans has increased to $19,500.
3. Pay off debt
More than 32% of respondents to a recent Policygenius survey said paying down debt is their biggest priority in the new year. The interest that debt accrues can take a big bite out of your finances, weighing you down faster than you can make up for with saving.
“Getting rid of high interest rate debts like credit cards is a high priority for many (especially after the holidays) and could be a great option for where to direct extra money,” said Feutz.
Getting a pay raise gives you an opportunity to pay down debt faster by allocating a portion of your larger paycheck toward your debt. Whether it’s a credit card balance, student loan, car loan or mortgage, paying a little extra every month will shrink your debt faster and save you money by reducing the interest you pay in the long run.
The best method for paying off debt depends on your situation. One popular strategy is the avalanche method, where you focus on the debt with the highest interest rate first to save money and get out of debt faster. Another popular strategy is the snowball method, where you focus on paying off debts from smallest to largest. This can help you score quick wins and gain the psychological boost of paying off debts.
4. Increase savings
Everyone should have an emergency fund to draw from when unexpected expenses arise, such as home repairs, medical bills or car breakdowns. Think of it as a financial safety net. A common recommendation is to save three to six months worth of income.
Even if that seems impossible, you should work on increasing your existing emergency fund (or start one if you haven’t already). Try to divert a little bit of extra money in your monthly budget toward your savings. It could make a huge difference when a financial emergency strikes.
High-yield savings accounts, certificates of deposit and money market accounts can grow your savings fund faster than traditional savings accounts. Consider opening one of these accounts to grow your savings, but remember that you’ll need to be able to access funds quickly in case of emergency.
5. Increase your life insurance
You need life insurance to ensure your family is financially secure if you die and can no longer provide for them. The amount of life insurance you need depends on many factors, including your family size, debts, number of dependents and home ownership.
A good starting place is to assume you need coverage that’s 10 to 15 times your current income. If your salary has significantly increased, your current life insurance policy may no longer provide adequate coverage. Policygenius offers an easy way to find a policy based on your new salary.
6. Review your first paycheck
When your first bigger paycheck hits, you should review it to make sure you’re earning what you should. Your paycheck will also show you, in exact figures, how much you can expect to take home after taxes, Social Security and other deductions come out. Make sure you’re plugging your actual take-home pay into your monthly budget.
Whenever you receive a pay raise, you should evaluate your finances and make sure you’re working toward your financial goals. But once you’ve allocated your newfound income toward some of these goals, you can celebrate with what’s left over. Start planning a vacation, saving for a new gadget or go out on the town! Getting a raise is worth celebrating.
“A hybrid approach could be to make sure that you’re intentional with half of your raise by directing it to high interest rate debt, savings or other financial goals while allowing yourself to spend the other half. It’s important to balance enjoying yourself and living for today with maintaining financial responsibility,” said Feutz.
Want to know how much you should be saving for retirement at your age? Read our article.
Have too much debt? Here are 50 ways to pay it off.
Here’s how to save more in 5 minutes or less.
Want to increase your savings? Here’s how high yield savings accounts can help.
Image: Nastia Kobzarenko