A pay raise is exciting, but it’s important not to overlook how that money can help you build wealth in the long term.
Here are three ways to handle finances better as you get raises at work:
1. Keep lifestyle inflation under control
First and foremost, the initial challenge for someone is to not increase your level of spending just because you’re making more money. There is a tendency to want to spend more when there is more money available. However, it can be extremely beneficial to longer-term financial goals if your mindset shifts from being a consumer to an investor/saver.
It might be difficult, but one way to think of it is to keep the same spending patterns (i.e., “lifestyle) intact despite having an opportunity to increase them, which will allow more resources to be used for specific financial planning goals. Spending more money just because you have it available is often called lifestyle inflation, and it’s a major reason why people can be living paycheck-to-paycheck on six-figure salaries.
By no means am I saying people should not enjoy their hard-earned pay increases. It is still very important to pay for things and experiences you enjoy — but there should be some level of balance when it comes to how you’re using your new income.
2. Consider how your raise can impact your long-term goals
When we talk about balance, we’re talking about striking the right ratio of money spent now to money set aside for the future — which might mean increasing your rate of savings in investment accounts or focusing on debt reduction payments (or both). With investments, there are some things that we simply are not able to control, like overall market downturns. However, deciding how much and often to contribute money to accumulating wealth are areas that are clearly within our control.
Upon getting a pay raise at work, you now have the opportunity to grow your assets more by saving/investing the additional cash flow, which can lead to an improved money situation over time. Take the following example that provides a simple comparison:
Mary performed exceptionally well at work over the past year, which resulted in her salary increasing by $6,000. She has decided that $1,000 of this extra cash flow will be used to dine out more often with family and friends, but the remaining $5,000 is allocated specifically for retirement plan contributions each year.
Mary is in her early 40s, maintains a 401(k) balance of ~$100,000, and currently contributes $10,000 per year to it. At her current annual contribution amount of $10,000 (assumed annual growth rate of 7%), Mary’s retirement savings would grow to ~$1.2 million over the next 25 years.
However, if she follows through with increasing her savings contribution to $15,000 per year, her total amount after the same time period would be ~$1.6 million instead — a noticeable difference. Mary used some of her extra money for enjoyment of life, but by deciding to not focus completely on spending to increase her current lifestyle, she has made a significant step in meeting a long-term goal.
Another great opportunity for those who receive pay raises is to pay off debt quicker, which ultimately frees up cash flow and allows you to focus more on asset accumulation. Certain types of debt (e.g., high interest credit cards) can be a major detriment to wealth-building, because cash is continually going to debt repayment, not asset growth.
A pay raise at work can provide someone who has higher-interest debt the option to expedite the process of paying it off completely. The faster a person can get to being debt-free, the more time they have to accumulate their own wealth.
3. Understand the potential of being in a higher tax bracket
This article has discussed all the great opportunities to take advantage of when earning more money at work. However, there is one more item that is not so fun, but must be discussed: taxation.
Quite simply, higher income generally results in an increased tax liability. It is important for you to consult with a qualified professional on this topic as you get (and continue to) receive pay raises over time. As you continue to move into higher tax brackets, tax planning conversations (and strategies) should be discussed with a financial planner and/or tax professional, which can be of great benefit to your financial situation.
Martin A. Scott, CFP, is the founder and financial planner of Lasting Wealth Principles, a fee-only comprehensive financial planning…