What should I do when I get a raise?

Congratulations! You got a raise!

Maybe your job gives you a basic cost-of-living adjustment and you get an extra 2% this year. Maybe you did a bang-up job on your projects this year and your boss bumped you up 5%. Or maybe you got a promotion due to longevity and the work you’ve done over time, and you got a 10% bump for the year.

In all of these cases, your income is going up for the foreseeable future. And that’s a good thing. Now, the key is making sure you take advantage of it and put that money to work in the best way possible.

Here’s the first guideline to consider. Prior to your raise, you were living off a certain amount of cash flow each month. Let’s use the example of someone earning $40,000 in a given year. After you factor in taxes, your take-home pay in this situation is likely somewhere around $30,000 for the year, or $2,500 per month. Now, I am not saying that you necessarily have to be happy living on $2,500 in income each month after taxes. I’ve met people who can live on half of that amount each month. I’ve also met people who need to live on double, triple, or four times that amount each month. There is no inherent “right” or “wrong” spending level.

Frugal people tend to look at high spenders and say that they’re being wasteful, where vice-versa, high spenders tend to look at frugal individuals and say they aren’t taking advantage of enjoying life to the fullest extent. I don’t want to get in the middle of that debate, because to be honest, each side has tradeoffs that different people are more willing to make than others. If you’re more willing to trade additional luxury today for additional choices in where you live and how much money you earn, the frugal path makes sense for you. If you’re more willing to take on a narrower slice of the jobs market and potentially working longer into life to gain luxury today, then higher spending appeals to you.

Let’s look at what happens if you get a 5% raise from your $2,500 per month salary. That’s going to bump you up to $2,625 in earnings after taxes. So you get an additional $125 per month. So here are some basic guidelines for what to do with that extra $125 per month:

      • If you have outstanding credit card debt charging you ridiculous interest rates, start throwing that $125 per month towards the debt to get it paid off more rapidly and avoid paying interest for things you bought a long time ago
      • Once your credit card is paid on a monthly basis, start getting your emergency fund built up. How big should it be? That depends on your situation, but get it to at least $500 to cover smaller things that might crop up, and then follow the link from earlier in this sentence to see how much more you need, based on your family situation

Those are the only two things that I view as truly necessary when it comes to choosing what to do when you get a raise. The reason for this is that both of these items go towards establishing a baseline of financial stability so you can wake up each morning without having to worry about how you’re going to pay every single bill. Beyond this, we start to get into choices that are still going to benefit you financially in the long run, but aren’t inherently required for you to have a stable financial situation.

What falls into these categories? A few things:

      • Increase your retirement contributions to your 401(k), Traditional IRA, or Roth IRA. Assuming you aren’t already maxing these accounts out, take the extra money you earn and put it towards retirement. It either means you can retire earlier or have more money in your account when you retire at the same date.
      • Start building up additional savings for a big purchase. Maybe you’re looking to buy a home or need a new car in the next couple years. Saving $125 per month for two years is going to give you $3,000 you can use as part of a down payment for a car or house. Will it cover the full cost? Nope. But it’ll help to reduce the amount you have to borrow for a mortgage or car loan.
      • Start an investment account. The main way that most people learn to save is through a tax-deferred or tax-free plan like a 401(k) or Roth IRA, but you can also put money into a brokerage account with no tax advantages that still allows you to buy things like stocks and bonds.

These are all ways that you can use that additional money if you get a raise.

You don’t have to go out and spend it. When you immediately take a raise that you get and use it to upgrade and improve things in your life, that’s called lifestyle inflation. You are effectively using your new income to buy things that you believe to be nicer than what you had before. And in some cases, this can make sense. Maybe you’re looking to move out of a dangerous part of town, or maybe you finally need to make those much-needed repairs to your home; these are good reasons for actually choosing lifestyle inflation. Getting away from things that may actively harm you is a really good reason to spend more money. But at a certain point, lifestyle inflation becomes something that can harm you as well, when you start to choose to make purchases and increase expenses based on status and image, rather than utility.

So here’s my second guideline when it comes to getting a raise. Once you get through the two necessary items mentioned earlier, paying off credit card debt and establishing an emergency fund, and once you are at a spending level where your safety isn’t threatened by your surroundings, try to save 80 percent of each raise you get. This allows you to experience a little lifestyle inflation when you get a raise. You did earn that additional money. You should enjoy a little of it, otherwise you might start to wonder what all the work is really for. But it also allows you to increase your savings rate, instead of just committing money to discretionary purchases. So in this example, with a $125 per month increase in take-home pay, you would allow yourself to spend $25 of that, but commit $100 of it to additional savings.

The money you save today is money you can then spend in the future, giving you more financial flexibility for the times ahead when you might not get the same level of raise, or may even have questions about the stability of your job. Committing to savings creates flexibility in the future by being a little more rigid today. When the world is as unpredictable as it is today, flexibility might be worth saving for, even though it means giving up a little spending in the present.