What Should You Do With a Raise?

Receiving a raise is a positive development, marking an increase in your earning power. This financial boost presents an excellent opportunity to strengthen your financial standing and pursue long-term goals. Thoughtfully managing this new income can lead to significant improvements in your overall financial health and security.

Revising Your Budget and Savings

An increase in income provides an ideal moment to revisit your financial blueprint and adjust where your money goes. Begin by updating your budget to reflect the new take-home pay. Intentionally allocate a portion of your raise to savings before it can be absorbed into new spending habits.

Building a robust emergency fund should be a primary focus, aiming to cover at least three to six months of essential living expenses. This fund acts as a financial safety net for unexpected events like job loss or medical emergencies. Keep these funds in an easily accessible, separate savings account, such as a high-yield savings account, to ensure liquidity while earning some return.

Beyond emergency preparedness, consider how your raise can accelerate progress toward other general savings goals. This might include accumulating a down payment for a home, or saving for a new vehicle or educational pursuits. Your increased income can significantly shorten the time it takes to achieve these objectives.

Accelerating Debt Repayment

Using your raise to pay down debt more quickly can significantly improve your financial flexibility and reduce the total cost of borrowing. Prioritize high-interest debts, which often include credit card balances and personal loans. Directing additional funds to these balances can save a substantial amount in interest charges and shorten the repayment period.

The “debt avalanche” strategy, where you focus on paying off the debt with the highest interest rate first, is an effective method for maximizing interest savings. After the highest-interest debt is eliminated, you can then apply those freed-up funds to the next highest-interest debt. Even small additional payments beyond the minimum amount can have a meaningful impact on your overall debt burden.

Consider also making extra payments on other types of debt, such as student loans or mortgages. While these may carry lower interest rates than credit cards, any additional principal payments can reduce the total interest paid over the life of the loan. This strategy can lead to substantial long-term savings and faster debt freedom.

Boosting Retirement and Investment Accounts

Leveraging your raise to increase contributions to retirement and investment accounts is a step towards long-term financial security. Begin by maximizing contributions to employer-sponsored retirement plans, such as a 401(k) or 403(b), especially if your employer offers a matching contribution. Contributing enough to receive the full match should be a top priority. An employer match is essentially free money.

Beyond employer plans, consider contributing to individual retirement accounts (IRAs), such as a Traditional IRA or a Roth IRA. These accounts offer distinct tax advantages that can help your savings grow more efficiently over time. Setting up automatic transfers from your paycheck or bank account ensures consistent contributions, making saving effortless.

The concept of compounding interest is central to long-term investment growth. The sooner you invest, the more time your money has to compound, leading to exponential growth over time. Even if you max out your retirement accounts, you can explore taxable brokerage accounts for additional investment opportunities, offering flexibility for various financial objectives.

Understanding Tax Implications

An increase in your income will affect your tax situation, potentially placing you in a different tax bracket for a portion of your earnings. The United States operates under a progressive tax system, meaning only the income that falls into a new, higher bracket will be taxed at that higher rate, not your entire income. Your previous income will still be taxed at its original, lower rates.

A higher income might also influence your eligibility for certain tax deductions or credits. Some tax benefits have income phase-out limits, meaning they become reduced or unavailable once your income surpasses specific thresholds. It is advisable to review your tax situation or consult with a tax professional to understand any potential changes.

Adjusting your federal and state income tax withholdings with your employer is a practical step to avoid either underpaying or overpaying your taxes throughout the year. You can do this by updating your Form W-4. Proper withholding ensures that you are neither hit with an unexpected tax bill at year-end nor providing the government with an interest-free loan through excessive deductions from your paycheck.

Mindful Spending and Lifestyle Management

With a raise, it is important to practice mindful spending and manage your lifestyle to avoid “lifestyle creep.” This phenomenon occurs when increased income leads to an automatic increase in spending on non-essential items, without a corresponding increase in savings or debt repayment. Resisting this tendency is important for maintaining financial progress.

While financial growth is a primary goal, a portion of your raise can be allocated for personal enjoyment or discretionary spending. This could involve experiences, hobbies, or small luxuries that genuinely enhance your quality of life, as long as it is done in a balanced way. The aim is to improve your current enjoyment without derailing your larger financial goals.

Before spending your increased income, consider how each expenditure aligns with your values and contributes to your overall well-being. A raise provides an opportunity not just for financial growth, but also for thoughtful improvements in your daily life.