It’s that time of year at the day job.
Every year, I get evaluated by my manager and receive the requisite pay increase to go along with it. This annual event brings with it the act of trying to decide what to do with any extra money that may soon to appear in my direct deposits.
All too often, we just let the extra money go into our spending accounts. While that might not be wrong, necessarily, there is an opportunity to give our finances a little something extra when our earning power increases.
In this post, I go through a process to determine if you might want to make some changes to the income part of your financial plan.
Step 1: Is My Take-Home Pay Actually Going to Increase?
If your pay increase is due to a promotion, it is quite likely that your take-home pay goes up…perhaps significantly. On the other hand, I’ve seen instances where an annual review type of raise, which tends to be around 2-3%, get eaten up by increases in withholdings for health and dental insurance. You may have some other items that chip away at that final take-home value at your place of work.
Whether you make changes to how your take-home pay is deposited into various accounts will depend on this, along with your overall financial situation.
Step 2: Do I Have Any “Bad” Debt?
If you are working through paying off credit card debt, student loans, and/or a car loan, whatever increase in pay you get should probably go to your spending account to pay that debt more quickly.
*This section assumes you are getting all of the available matching from your employer in your retirement accounts.
Step 3: How Much of a Raise am I Working With?
Obviously, if you get a bigger raise you will have more flexibility. The key here is to try to make sure your lifestyle creep is slower than your pay increases for some portion of your life. Once you hit your targets (covered in Step 4), you can coast a little more.
If your increase is of the cost of living type, 2-3%, this process will obviously be more difficult.
If you’ve earned a promotion, you have a lot more flexibility. Early in my career, I actually got a pay increase of more than 30% from a promotion; most other promotion-type pay increases I have experienced have been in the 8-10% range. For these types of raises, it’s okay if you want to let your lifestyle creep with a portion of it; I would just advise to try to limit the creep to half of your increase in pay or less. Pay yourself with the rest of that money.
Step 4: Which Account or Accounts Gets the Extra Oomph?
Once you’re pretty sure that your take-home pay will increase, you can determine which accounts you want to put some more financial force behind. I have a spreadsheet that helps me plan (because of course I do), but we usually don’t know for sure until the raise actually takes effect. Here’s the order I like to use:
- Employer-Sponsored Retirement Accounts (401k/403b) and Emergency Fund
- For 401k/403b accounts, contribute enough to get all of your employer’s matching funds; work toward a rate of around 15% of your pre-tax income going to these accounts.
- For the Emergency Fund, contribute an amount that will build toward and sustain a balance equal to at least 3 months of expenses. What savings level that is depends on each persons own finances. I am currently at 10% of take-home pay going to an emergency fund; I’ll see how that works out long term. If you haven’t started an emergency fund, start contributing 2% to a savings account and work your way up 1% at a time.
- Other Tax-Advantaged Investment Accounts and Discretionary Savings
- Tax-advantaged investment accounts: The next consideration is to think about increasing contributions to tax-advantaged investment accounts outside of your 401k/403b, such as IRAs, 529 plans, or Health Savings Accounts.
- Discretionary Savings: Over the past year, I’ve become a big fan of discretionary savings accounts. Discretionary savings accounts are for spending on some bigger ticket items that don’t fall into the emergency category. This account is also a great way to increase your savings rate when you might be a little timid about giving up some spending money. If you overextend to a point where you have trouble paying all of your bills, the money you’ve deposited in this account is still there for you. Basically, it’s easy to undo an overshoot on a direct deposit increase from this type of account.
- Taxable Investment Accounts: This type of account, like the discretionary savings account, is your money to do as you please. I advocate for doing the discretionary savings before you start with taxable investing for a couple reasons:
- You’re investing here; not saving. While the returns may be much higher in the long run, there are also greater risks of losing money in the short run. Basically, this is not the place to experiment with money you may need in the short term.
- If you sell any investments, it can impact the amount you pay in taxes. You may want to consult a financial advisor for more details on how you should invest in this type of account.
- If you have a long-term goal (more than 5 years out), and you are happy with your savings levels in the other accounts, (401k and other retirement accounts are going strong, emergency savings is well funded, and you have discretionary savings to help you out with the fun stuff) you may want to put some of your hard-earned pay increase to work for you in a taxable investment account.
- You may want to speak to a financial advisor about the best way for you to invest your money based on the goals you have.
I like to set up my deposits as a percentages of the total. This year’s raise was enough for me to increase my contributions to my 401k and my discretionary savings account, while still maintaining my spending account deposit level at roughly the same dollar amount.
May this walk through my process help you come up with your own system for revving up your own finances as your income increases.
Thank you for reading.