That day has finally come. You got the raise you’d been hoping for. But before you rush out and purchase a new car or house, maybe you should consider how this raise could really help your finances.
So many people live above their means or at least live just slightly within budget. Instead of applying that raise to a luxury item, let’s look at how you should use a pay raise.
Increase Your 401(k) Contributions
The sad reality is that a pay raise means paying more in taxes. It may even throw you into a new tax bracket for the increased earnings. One way to combat this is to invest more money into your 401(k).
The money you invest in your 401(k) is non-taxable until you withdraw it. You should be aware that not only will a pay raise mean more taxes, but the amount going into your 401(k) will increase regardless of if you increase the percentage or not. In other words, you may not have a lot of extra income after this occurs.
Pay Off Debt
If you have debt, what’s left of your raise should be applied to paying that debt off. That doesn’t mean some of your raise can’t be used for fun. Use the percentage rule and give yourself 5 to 10% of your income for play money. What this does mean is you’re going to be paying more on your debt and hopefully digging yourself out of that hole.
Build an Emergency Fund
If you don’t have an emergency fund, and have paid off your debt, the pay raise would be best utilized in an emergency fund. An emergency fund should consist of at least three to six months of expenses. This money is to be used should you lose your job or be out of work for an extended period of time due to illness or injury.
Consider Your Goals
If you’ve already taken care of your debt and have an emergency fund, consider what your other goals are. Do you want to retire as soon as possible? If so, invest the money into an IRA or another type of investment, such as a rental property or peer-to-peer lending.
If your goal is a dream vacation, start an account and put your raise (after your 401(k) contributions and taxes) toward that goal. Whatever your goal is save the money until you can pay for it with cash rather than credit.
A pay raise makes many people want to rush out and get a new car or move into a new house. Don’t let the extra money cause you to make big mistakes. Sit down and see how much money you’ll really be getting after the increase to your 401(k) and taxes have been taken out. Then you can start thinking about smart ways to use that money.