It’s a typical Thursday afternoon. Out of nowhere, your boss requests a quick chat. After some good-natured banter about the kids, the weather, or last night’s finale, you’re told that your performance at the company has not gone unnoticed — in a good way. As a show of appreciation, you’re getting a raise.
You express your gratitude and exit the meeting with a proper poker face to avoid unwanted questions from curious co-workers. Then, somewhere between the potted ficus tree and the elevator, you do a little happy dance and text your spouse with the news.
Now, before you book that vacation to the Maldives or make an appointment with the luxury car broker, you might want to take a moment and make a plan. Handled properly, a raise may ease some financial stress today and give you added confidence as you prepare for the future.
Do the math and calculate what the pay increase really means after taxes. If it’s a very modest bump, maybe enjoy a nice dinner out, toast the occasion, and then keep doing what you’re doing. If it’s a noticeable increase (even an extra $50 per paycheck can impact your budget), you might want to crunch the numbers and decide how to allocate the extra income.
Following are just a few areas to consider:
Doug Ewing, a Certified Financial Planner® and Director of Advanced Markets with Transamerica, has some areas to consider. And don’t worry, it’s not all about “ants getting ready for winter”. There’s room for some fun, grasshopper. We’ll get to that.
As you review your personal finances, take a look at your emergency fund.
“Most financial professionals would tell you that before you do anything, you should make sure you have enough money saved to cover at least three to six months of expenses,” Ewing says. This can provide added peace-of-mind in the event of unexpected medical costs, a job loss, or a significant home or car repair.
An emergency fund is typically kept in liquid accounts so those dollars are accessible without an early withdrawal penalty.
“You want to be able to cover fixed monthly expenses without having to do anything rash,” says Ewing.
If you’ve put off building that financial cushion — or maybe that cushion just needs a little fluffing — think about allocating an appropriate percentage of your raise to make it happen. If you set up automated, scheduled deposits you won’t have to give it a second thought.
By this point in your life, you’ve been told approximately 1,453,657 times that carrying credit card debt is an expensive way to borrow money. We won’t belabor the point. If you still have some hanging around, this could be a good time to get rid of it. As you reduce your financial burden, you'll possibly reduce the stress that comes with it.
Regarding other debt, some people might be inclined to pay down a mortgage. But here’s something to consider: Suppose you get a raise and decide to aggressively pay off your mortgage. If something happens to your income down the road, like a job loss, you’ve got a lot of money locked up in the house that you can’t access. In this situation, your money might be better kept in a savings account.
Perhaps there are times in your life and career when, for various reasons, you’ve dialed back on your workplace retirement contributions. Now may be the time to make up lost ground. Having a little more money in your paycheck can make it easier to fund a 401(k) without noticing a big hit in your take-home pay. Of course, there are some things to consider.
Make sure you’re familiar with the limits for annual contributions. In 2017, people under 50 years of age can contribute up to $18,000 annually. If you’re 50 or older, you’re allowed an additional $6,000, for a total of $24,000 annually.
How much you contribute is part of the equation. Another factor is how you allocate those dollars. Do you want to put it into a traditional 401(k) or a Roth 401(k)? As you probably know, contributions to a traditional 401(k) are tax-deferred, meaning you pay taxes upon distribution. You may also benefit from lower taxable income each year. On the other hand, money put into a Roth 401(k) goes in after you’ve paid taxes, so the distributions are tax-free – with a few stipulations.
Ewing points out there are pros and cons for both, but notes there might be possible advantages with the Roth option. And he illustrates his point with this example: If you put $100 into a traditional 401(k), you’re saving money because it’s a pre-tax contribution — and, of course, you’ll pay that tax later. To contribute $100 to a Roth 401(k), it’s going to cost you about $125 right now due to taxes, but those dollars will potentially grow tax-free.
If you’re disciplined enough to re-invest the tax-deferred savings from a traditional 401(k) plan contribution elsewhere, then that’s not a bad route. With the Roth 401(k), you’re paying more now, and possibly worrying less about taxes later.
Consider Both Traditional and Roth Options
This is not to say it’s one or the other. Ewing sees the potential benefit of contributing to both types of plans.
“For younger savers – who may not be in a high tax bracket yet – the Roth 401(k) can make a lot of sense,” Ewing says.
He points out that many older savers tend to have most of their retirement savings in a traditional 401(k), and that can have tax ramifications in retirement. For this reason, older savers might want to defer some portion of their contributions to a Roth to increase their tax diversification in retirement. It’s best to consult with a financial professional to discuss what’s right for you.
Some Fun Stuff
You’ve likely worked hard to earn this raise, so you shouldn’t feel guilty about spending a bit of it on something you enjoy. If you want to feel especially good about splurging, perhaps invest in something that could reap healthy rewards as you age and prepare for retirement. Maybe a new bike instead of the home theater system? Or a good gym membership instead of the Cigar-of-the-Month Club?
As for Ewing, he recently bought a new set of golf clubs and replaced his well-worn 17-year-old bag of woods and irons.
“It’s okay to treat yourself,” he says. “You’ve got to be happy in the here and now.”
Things to Consider:
• If you don’t have an adequate emergency fund, you might want to put part of your raise towards shoring up 3 to 6 months of living expenses.
• Think about paying off any lingering high-interest debt, i.e. credit cards. You don’t necessarily need to prioritize paying off your mortgage as that locks up money in your house. Instead, you might invest that money in savings or other accessible accounts.
• A salary increase could be a good time to recommit to maximizing your contributions. Weigh the benefits of a traditional 401(k) and a Roth 401(k).
• It’s okay to treat yourself. You’ve earned it.
Neither Transamerica nor its agents or representatives may provide tax or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal advisors regarding their particular situation and the concepts presented herein.