Getting a raise or promotion is a great thing. The additional income can help with many of the day to day financial struggles that we contend with. But, when many people receive a raise or promotion, they mismanage the additional income by taking on new debt or expenses, attempting to upgrade their standard of living by taking on additional revolving debt or monthly payments.
At compounding returns, we believe the smartest thing you can do with a pay increase is to pretend you never received it. This is absolutely counter to what many people, who run out and try to spend the additional income as soon as possible, do. But pretending you never received this pay increase will help you set a course for financial independence.
Living as if you have not received a pay increase requires that you have a working monthly budget. This will allow you to track expenses and ensure you are maintaining the same standard of living. If you haven't developed a monthly budget, try Mint.com for an easy to use online budgeting tool that automatically tracks your expenses by category.
Keep in mind, this plan only works if your current standard of living is sustainable, meaning your home and family are safe, well fed and secure, and you are not in dire need of immediate change. So, for those of us who fall into this category, what are the best things you can do with a salary increase? Here are some ideas, in no particular order:
Pay off credit card debt: A salary increase is a great opportunity to increase the payment you are applying to your debt repayment strategy. Dave Ramsey's book The Total Money Makeover: A Proven Plan for Financial Fitness, advocates the use of a debt snowball. Using this salary increase to bolster the payment amounts applied to your debt snowball will result in paying off debt at a much faster pace, and is an excellent use of your additional income.
Build up your emergency fund: If you have not yet funded, or still need to save additional money in your emergency fund, another good strategy for your raise could be diverting the balance of your salary increase into your easily accessible online savings account, such as ING Direct. Seek to grow the balance of this account to the next incremental level.
Invest in needed maintenance/ repairs to your possessions: The only thing worse than paying for expensive car repairs is buying a new car because you neglected to pay for the intermittent mechanical malfunctions associated with automobile ownership. If you have been putting off home or auto maintenance, medical appointments, or any other expenses because you couldn't afford them, a raise might just give you the boost you need to afford these preventive maintenance measures, and save yourself a bundle down the road.
Make savings automatic: With the advent of online banking came a remarkable ability to make savings completely automatic. This is a highly recommended way to put your savings on autopilot and ensure that you are contributing to your interim goals and retirement without having to remind yourself every month. We recommend saving as much of your pay increase as possible by setting up automatic transfers into a high yield savings account at the beginning of each pay period, before you take money out for discretionary expenses.
Increase 401K contributions to lower your tax bracket: If you earned a significant raise, congratulations! One of the best things you can do, if you find yourself bumped up into a higher tax bracket is contribute as much as possible to your 401K account. This can both lower your taxable income, and set you up well for retirement when your income will likely be less. In 2011 you can contribute up to $16,500 to your 401K if you are under 50, and $22,000 if you are over 50.
Increase Roth IRA contributions: If you fall under the income limits for Roth IRA contributions and are not contributing the maximum allowed amount, you are missing out on an excellent opportunity for tax sheltered savings. You can contribute up to $5,000 dollars of after tax income annually to a Roth IRA. When you withdraw the income after age 59 1/2 all of the withdrawals are tax free. Please visit www.irs.gov for more information, including income limits.
Start itemized savings accounts: Got big plans or a big purchase on the horizon? Start itemized savings accounts for these purposes. Nothing feels better than saving for a vacation, new luxury item, new car, or other large expense and being able to pay cash for it, knowing that you are being financially responsible even when you splurge!
Start a 529 plan for your kids: 529 plans offer an excellent opportunity to shelter your kids' or your own educational savings account from the tax man. Look into this option if you have plans for future education for yourself, your children or grandchildren. Being able to pay for advanced education without going into debt is the single greatest thing you can do for yourself and your progeny.
Spend some of it: What is life without a little fun here and there? Just be responsible. Save the money in an itemized savings account or otherwise budget for the purchase, and enjoy the fruits of your labor.
Congratulations on your raise or promotion. Hopefully, this list will help you responsibly enjoy the extra cash that you have worked so hard for while being responsible with the additional funds.