Are you making more money than you used to make? Whether you landed a new job or received a promotion, your pay increased. What do you do with this increase? Of course you want to celebrate and start spending more. But WAIT. It’s important to think about how to handle this additional money. Here are 5 steps to wisely use your salary increase.
Step 1: Take 10% of your AFTER-tax increase and splurge.
It’s hard not to splurge after receiving a salary increase. So don’t deprive yourself – but do limit how much you splurge.
Why after-tax? Well, you want to make sure you know how much money will be deposited into your checking account since you can’t spend money going to Uncle Sam.
For example, Karen is paid monthly and will receive an additional $1,000 after-tax. Every month, she will take $100 ($1,000 * 10%) and splurge on whatever she wants.
Step 2: Check your tax bracket.
Your salary increase may bump you into another tax bracket (the key reason to wait in Step 1). Check tax tables or ask you CPA.
If you’re in a new tax bracket, review your tax withholdings at work. Also, discuss with your CPA and financial advisor tax efficient strategies to manage your money.
Using the same example, Karen’s initial salary was $87,000. With her salary increase, she moved from the 25% tax bracket to the 28% tax bracket.
Step 3: Add money to your emergency reserve.
An emergency reserve is money you save to use for unexpected expenses such as car repairs, household repairs, medical expenses or even if you become unemployed.
Make sure you have an emergency reserve to cover your regular expenses for at least 9 months (if dual income household) or 12 months (if single income household). You may have heard saving 3 to 6 months of expenses, but in reality it takes longer than 6 months to find a job if you become unemployed (and the more money you make, the longer it takes).
For example, Tim spends $4,000 per month. This amount includes expenses for his home, transportation, personal care, food, entertainment, pet, medical, gifts and insurance. Since he is single, he needs $48,000 in his emergency reserve. To date, he has $15,000 in that account. Tim decides to allocate 50% of his additional salary towards building his emergency reserve.
Step 4: Increase your retirement savings.
Even if retirement is far out in the future, it’s important to start saving early. Most people live at least 20 years in retirement – sufficient savings is required to maintain your lifestyle AND pay for healthcare (Medicare will cover only a portion of your healthcare).
For example, Tim is 30 years old and spends $100,000 per year. He currently has $50,000 in his retirement savings. To maintain his lifestyle in retirement, he needs to save almost $3 million. While this number seems large it really isn’t when you factor in his retirement is 35 years away. Breaking this amount down, he needs to save around $23,000 per year.
There are many online retirement calculators to use to determine how much you should save for retirement. Determine how much you need to save and stay disciplined by automating deposits to your retirement savings (which is easy to do if your firm has a 401(k) plan). And every time you receive a salary increase re-evaluate that amount.
Step 5: Prioritize other goals.
Prioritize your other financial goals and allocate money towards achieving those goals. List your goals. Your goals may be to pay off your student loan, reduce your debt, buy a new car, buy a home, renovate your home, buy a vacation home, fund your child’s college education, etc.
Once you develop this list, then prioritize the order of importance. For example, your top 3 financial goals may be
#1 reduce debt
#2 buy a new car
#3 buy a home
With your salary increase, you may decide to allocate 50% to reduce debt, 25% to buy a new car and 25% to buy a house. As you accomplish each goal, your priorities will change. Review your list of financial goals at least once a year and adjust as necessary as your circumstances change.
We all want to celebrate when we receive a salary increase. But it’s important to think through how this additional money can help you reach your goals in life. Dedicate a certain amount to splurge then apply the rest to realizing your goals.
ABOUT THE AUTHOR:
Niv Persaud, CFP®, CDFA™, CRPC®, is the Founder of Transition Planning & Guidance, LLC. Her firm bridges the gap between financial planning and coaching. As a Transition Consultant, she offers sage advice in all aspects of life – financial, personal and professional. Niv does not manage money and does not sell financial products. Her services include spending plan development, divorce financial review, life strategy and professional progression. Niv actively gives back to her community through her volunteer efforts. She believes in living life to the fullest by cherishing friendships, enjoying the beauty of nature and laughing often — even at herself. Her favorite quote is by Erma Bombeck, “When I stand before God at the end of my life, I would hope that I would not have a single bit of talent left and could say ‘I used everything you gave me’.”