Q&A: How Should I Handle a Pay Raise?
Q: Hallelujah — I’ve gotten a pay raise! I’m thrilled, of course, but how should I work this extra income into my monthly budget? What’s the financially responsible way to handle a raise?
A: Congratulations on your raise! It’s always exciting to experience an increase in income, but if you aren’t careful, lifestyle creep can make your boosted income burn right through your monthly budget. Here’s how to handle a pay raise responsibly.
Adjust your budget
It’s important to adjust your budget soon after receiving a pay raise, but be sure to do it strategically. Before you start spending, take a close look at your budget to determine how the additional income fits into your financial circumstances. If you’ve been tight in some spending categories, you can increase your allotted monthly amount to make things a little easier.
Be careful to avoid lifestyle inflation, which is the tendency to increase spending as your income grows. Instead, allocate your raise to areas that can improve your financial stability and quality of life. If your budget has been working well for you until now, there’s no need to make changes to any spending categories just because you now have a little more breathing room.
Read on for additional ways to use that extra income.
Pay off debt
If you’re carrying a large amount of unsecured debt, you can easily be paying hundreds of dollars a month toward the interest charges while barely even touching the actual debt. Take the opportunity that’s been afforded by your pay raise to kick that debt for good.
First, you’ll need to decide on a debt payoff plan. You can choose the avalanche method, where you pay off the largest debt balance first, and then move on to the second-largest, and so forth. Alternatively, you can go with the snowball method, which starts with the smallest balance, and moves on to the second-smallest until you’ve paid off all your debt.
Whichever method you use, allocate part of your extra income toward maximizing payments on the debt you’re paying off first, and keep at it until you’re completely debt-free!
Maximize your savings
Another great way to use a pay raise is to amp up your savings. Take some time to review your short- and long-term saving goals and your set timeline for those goals. Which of these are important for you to reach sooner? You can use your additional income to make it happen quicker!
You can also choose to divide some of your new income evenly across all your saving goals so each one happens just a bit sooner. Or, set a new goal and allocate all the funds toward it.
Don’t forget to automate a regular transfer to your savings account(s) so you never forget to feed those dreams.
Build or boost your emergency fund
Financial experts recommend having three to six months’ worth of expenses saved for emergencies. If your fund is lacking, use part of your raise to fortify it. If you don’t have an emergency fund, it’s wise to use your increased income to start building one now.
Increase your contributions to employer-sponsored benefits
With a higher salary, you may have room in your budget to take better advantage of workplace benefits. Options to consider include:
- Retirement plans. Consider upping your contributions to a 401(k) or IRA. If your employer offers a match, take full advantage of it.
- Health Savings Accounts (HSAs). If you’re eligible, maxing out contributions can provide tax advantages and help with future medical expenses.
- Supplemental insurance. Evaluate whether additional life or disability insurance is a good investment for your family’s security.
Tax implications to consider
A higher income could place you in a new tax bracket, potentially increasing your tax liability. Review your tax withholding to ensure you’re not caught off guard during tax season. Consulting a financial advisor or using a tax calculator can help you estimate the impact.
Have fun!
While it’s smart to focus on financial goals, it’s also important to celebrate your hard work. It’s perfectly OK to set aside a small portion of your raise for discretionary spending — whether that’s dining out, upgrading your wardrobe or pursuing a hobby. A common guideline is the 80/20 rule: Set aside 80% of your raise for savings and debt reduction, and use the remaining 20% for enjoyment. You’ve earned it!
A pay raise is more than a financial boost — it’s an opportunity to create a brighter financial future. Use these tips to learn how to make a pay raise work for you.