So you’ve received a raise. Congrats! You’ve earned that extra cash through your hard work. Now there’s just one question: What should you do with the additional money?
“Determining the best use for a raise is a very personal and individualized decision,” said Joseph Hogan, a certified financial planner and director of financial planning for Mariaca Wealth Management.
To help you make smart choices, follow this four-step guide compiled with the help of financial experts.
1. Avoid lifestyle inflation
First, experts agree that you shouldn’t allow expenses to creep up. That could negate the value of your raise.
“A common mistake people make when they receive a raise is they don’t formulate a plan and just allow the additional monies to be added to their checking account,” warned Maggie Johndrow of Johndrow Wealth Management. “This money will likely be spent on unnecessary items.”
Lifestyle inflation is bad news because you can quickly adjust to the extra cash. And spending it frivolously likely won’t bring you long-term happiness.
“People move into a bigger apartment or buy a more expensive car to reward themselves for receiving the raise,” said Robert Johnson, principal at Fed Policy Investment Research Group. “They’re unable to improve their financial condition because they spend everything they make.”
The good news is that you don’t have to waste your raise. Instead, you can put your extra income toward savings or debt.
In fact, Ellie Thompson, founder of Money Therapy, said you should prioritize your financial obligations above everything else.
“Unless you already have a fully funded emergency account, have no debt, and are contributing to your retirement, you simply cannot afford to increase your lifestyle,” she said.
2. Evaluate your financial goals
Unfortunately, there’s no one-size-fits-all approach to using a raise wisely. Different people are at different stages in their lives. One person may be better off using the raise to repay debt while someone else might be better off padding their emergency savings.
“An employee receiving a raise should look to their short-term and long-term goals to determine the best use,” Hogan advised.
Consider how the money can help you reach your financial goals. For example, paying off your debt a year or two sooner may be more gratifying than a shopping spree.
You could also look to invest the extra cash. You could invest in your side hustle or start saving for a home, which could build value over time. But you may be better off first boosting your savings.
Thompson suggested creating an emergency fund, then paying off debt and contributing to retirement accounts.
“If you don’t have an emergency fund that can cover at least three to six months of expenses, putting those extra dollars towards creating an emergency fund should be your first priority,” she said, adding that an emergency fund could prevent you from taking on high-interest debt if an unexpected expense crops up.
Johndrow similarly recommended focusing on savings and debt repayment. She advised that you take a careful look at your debt and consider paying off your highest-interest debt first.
This doesn’t mean you can’t use any of the money for something fun. “If you want to use a portion of your raise for a vacation, add that to your financial plan and budget alongside your other savings,” Johndrow added.
The key is learning to make a plan for your money. If you want to make a frivolous purchase, work it into your budget.
3. Consider the tax implications of your raise
While you’re making grand plans for a bigger paycheck, don’t forget to take increased taxes into account.
“Depending on the size of the raise, consider if the additional money will change which income tax bracket you’re in,” said Johndrow. “If so, are you prepared to pay higher taxes?”
You may need to adjust your tax withholdings. You should be mindful of whether your raise will push your income so high that you lose eligibility for deductions or credits you’ve been claiming, such as the earned income tax credit.
If your raise will result in a bigger tax bill or cause you to lose credits and deductions, Johndrow recommended allocating more money to pretax retirement plans, such as a 401(k) or an individual retirement account, or IRA.
“That may lower the size of your tax bill at the end of the year,” she said.
4. Put your plan into action
Once you’ve decided on what to do with your extra money, put your plan into action. To make this easy, automate the process.
“I would set up an automatic and [recurring] debit from your paycheck straight into your savings account,” Johndrow said. “Everything you want to save should go straight into a saving account. If your savings are in your everyday checking account, you’re less likely to transfer it into your savings accounts and more likely to spend the money.”
Automating deposits into a high-yield savings account could be a great way to meet short-term goals while earning interest on savings. Similarly, you could automate payments on your debt or increase your contribution amount on your workplace 401(k).
By automating your savings and debt repayment, you can avoid the hassle of mulling over how to manage your money. But making periodic check-ins with your accounts is important. Doing so comes with the added benefit of seeing yourself moving closer to your financial goals.
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