Getting a raise is a joyous occasion as you now have access to extra funds—but how should those funds be used? For those working from a financial plan with a carefully detailed budget, it may be an easy adjustment. But from my experience, that is not a huge percentage of people. For the majority of the people that are less in tune with their finances, now is the time to put together a budget, get organized and prioritize the application of additional funds from the raise.
Pay off debt
The first priority is to pay off debt, especially debt with a higher interest rate. Start with credit cards, particularly the card with the highest rate. For other debts, like auto loans, personally guaranteed loans or student loan borrowings, again focus on the higher rates. When it comes to mortgages, it might not be prudent to pay extra on the principal balance—depending on the interest rate and the possible tax benefits reaped from the mortgage interest.
Build up emergency reserves
Assuming high rate debt is gone, the next important area of attention should be building up reserves. Emergency reserves can take multiple forms, including bank holdings and CD’s, life insurance cash-value or a home equity line of credit.
Even after receiving a raise, it is important to plan for a worst-case scenario—such as loss of employment. Saving six months to a year of expenses is a good rule of thumb, but it’s also important to consider this question: what amount do you need immediately available to ensure a peaceful night’s sleep?
Create a reward fund
Here’s the best part about putting together a new budget–you can include a line item for personal enjoyment. A raise is a reward for hard work, and what better way to enjoy that reward than through the creation of a leisure account. This money can be used for trips, hobbies or any other special items you’ve delayed purchasing due to lack of funds.
Increase retirement funding
After the basics are covered, it is time to shift focus to retirement savings. This might include an increase in 401(k) or 403(b) contributions, especially if you are not putting away enough to enjoy the full company match. Increasing retirement plan contributions serves two purposes: saving on income taxes and accumulating retirement funds. For those that are maxing out their 401(k) contributions, there may be a benefit to non-deductible contributions either within the company plan or to an IRA.
After paying off debt, building emergency reserves, creating a leisure account and maximizing retirement contributions, it’s time to put additional funds into an all-purpose brokerage account. This fund is a reserve for retirement, education, vacation, second homes or any other goals that present themselves.
Getting a raise is a great opportunity to review and refocus a financial plan. Don’t hesitate to contact a CERTIFIED FINANCIAL PLANNER™ professional
to help you prioritize how to best use that extra money.