Congratulations if this question speaks directly to you. There are in fact people out there in the world that are currently earning raises. The times of pay freezes in some industries seems to be slowing. After you have earned a raise, you may ask yourself: What should I do now with the extra money? This speaks to financial literacy and the trend that people are embracing financial responsibility.
Perhaps the natural tendency for us when we receive a raise, is to celebrate, and spend this extra income on luxuries, a car or things for the house. But in fact, the first thing to do is actually calculate the increase to know what you’re working with. Often people don’t take the next step of understanding the difference between your gross income, versus net income which is your take home amount.
Did you know that the general rule of thumb when you receive a raise is to save half and then put the remaining half towards reducing debt, if applicable? By saving half, I’d recommend first looking at your emergency fund to have some available dollars accessible to handle unexpected dilemmas. This is the buffer and support you need when life happens to throw you a curve ball.
Then it’s wise to move on to your pre-tax salary deferral plan that is available whether that is your 401k, 403b or company retirement plan. How much do you currently contribute to this account? If you’re able to contribute even 1% more, there are advantages. These pre-tax advantages need to be analyzed before you decide to apply your entire raise toward debt. Reason being is the pre-tax savings could save you the equivalent of your income tax bracket, perhaps even 25%, whereas your credit could be at 12%. As your budget allows, an overall goal is to work toward saving a minimum of 10% of your income and funding your pre-tax plan to the maximum. Each company plan has different maximum IRS and plan funding limit. This is not the same thing as the amount your employer is matching. Employees often think they are funding the maximum, while we later discover they are funding the maximum their employer is matching; for example 5% or 6% so that’s a big difference versus $17,500, or $23,000 if you’re 50 or older.
If you’re working on reducing a substantial amount of debt the natural first inclination is to apply most money from your budget to that. While it is true getting organized and creating a strategy to tackle debt is the priority, it will also be important to take the next step and rank the debt versus the advantage of putting more into your retirement account.
By having a game-plan and organizing your finances, when changes happen in your life, you’ll be equipped to address new opportunities and address financial concerns more quickly. You will have provided yourself with the framework to handle most unexpected events. Though it may not be fun to put the most you can into a pre-tax savings plan, if you’re used to living on your current budget it will be to your advantage to most efficiently account for increased take home money. By deferring it immediately you won’t miss it and you’ll do yourself a huge service over time by accumulating investment potential, tax advantages as well as future income availability. That could be the key to perhaps allow you an earlier retirement, stronger cash flow of future income and stability near the bridge of retirement.
Please call Ed or me if we can assist you or someone you know!