Got a Pay Raise? 6 Wise Strategies to Manage Your Extra Money
Congratulations on your pay raise or bonus! Now it’s time to get serious about how to use that extra money to improve your finances. Laura covers six wise strategies to create more security, so you don’t fritter away an exceptional opportunity to build wealth.
Laura Adams, MBA
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Got a Pay Raise? 6 Wise Strategies to Manage Your Extra Money
It’s the time of year when you may have received a pay raise or year-end bonus and be unsure about the right way to spend it. Congratulations, it’s a great problem to have!
Before you’re tempted to spend a windfall on something frivolous, consider how it could be used to create more financial security instead. In this post, I’ll cover 6 strategies to wisely manage extra money so you don’t fritter away an exceptional opportunity to improve your finances and build wealth.
6 Strategies to Manage Extra Money Wisely
One of the first impulses we usually have after getting a bigger paycheck—or any unexpected income for that matter, such as a tax refund or inheritance—is to upgrade our lifestyle. Maybe you’ve been thinking about buying a bigger home, moving into a better apartment, getting a new car, or joining an exclusive gym or country club.
Increasing your expenses to match your income is called lifestyle creep. It’s one of the biggest dangers to your financial future because it doesn’t seem like a bad or crazy idea at the time.
You might believe that you deserve to buy something pricey or make a luxurious lifestyle change after working hard for your raise or bonus. And maybe you can afford it on paper.
I’m not saying that you shouldn’t enjoy your additional income. But what I recommend is that you take a hard look at your finances and use this opportunity to strengthen your foundation before committing to bigger expenses or luxury purchases. Letting extra cash slip through your fingers to finance a more expensive car loan or pay more rent means that you’ll miss a huge opportunity to build long-lasting wealth.
Now’s the time to refocus your goals. If you missed the previous Money Girl Podcast, The Simple Truth Behind Growing Rich, it will help you figure out what you want to accomplish with your life and finances. Ask yourself questions like:
- Should I make a career change or start a business?
- How would I handle an unexpected financial hardship?
- What type of lifestyle do I want in retirement?
- Do I want to retire early?
- Would my family be safe without me or my income?
Thinking though tough questions helps you know how extra money can help you get what you want out of life. Use these 6 strategies to manage your additional income wisely:
1. Fortify your emergency fund
The best way to make sure you’re ready when bad luck strikes, is to prepare for it today.
The best way to make sure you’re ready when bad luck strikes, is to prepare for it today. No matter if you have a small unexpected expense, like a car repair, or something major like getting sick or losing your job, you need a financial safety net.
Devastating events are tough enough to handle without also being stressed about money. When you don’t have a financial cushion to soften the blow of a large expense or a loss of income, you end up relying on credit cards.
Yes, it’s good to have credit as a last resort. But please understand that it’s an expensive option because high interest gets added to your balance every month until you pay the entire balance. For many, using a credit card as an emergency backstop puts you in a huge financial hole that can take decades to climb out of.
That’s why your number one financial priority before doing anything else, such as investing or paying down debt, should be to accumulate an emergency fund. Studies showopens PDF file that 46% Americans couldn’t come up with $400 to cover an unexpected expense. I don’t want you to be a part of that statistic.
Having at least a couple months’ worth of living expenses, and ideally a minimum of 6, on hand gives you a tremendous amount of peace. You’ll know that you’ve got money to deal with just about any distressing situation that blows into your life.
So, if you don’t have a healthy emergency fund sitting safely in a bank savings account, use every bit of your pay raise or bonus to start building one. Get a tax refund? Pile it on top and feel empowered.
Don’t worry if your cash reserves earn little or no interest in the bank. They’re not supposed to. The purpose of emergency savings is to be accessible and liquid in the short term. If you invested your emergency money, the value could shrink to nothing the moment you need it.
See also: 5 Tips to Build a Financial Safety Net
2. Fill your insurance gaps
In addition to using extra income to create a financial cushion in the bank, another critical way to protect yourself and those you love from something unexpected jeopardizing your financial security is having enough of the right types of insurance. Without it, a catastrophic event—such as a health problem, car accident, natural disaster, or a death in your family—could wipe out everything you’ve worked so hard to earn.
Managing different types of risk is easy, in a financial sense, because most of them can be transferred to an insurance company.
It’s not pleasant to think about what bad things could happen, which is precisely why so many people are underinsured. But managing different types of risk is easy, in a financial sense, because most of them can be transferred to an insurance company.
Health insurance is the most important coverage to have because any kind of medical issue or accident could leave you with a massive bill. Even a quick trip to the emergency room or a short hospital stay could cost thousands of dollars.
No matter what changes the Trump administration makes to the Affordable Care Act, you still need a health plan to protect both your health and your finances. If you don’t get health insurance through work, use a resource like insuranceQuotes.com or Healthcare.gov to find out your eligibility for benefits including Obamacare, Medicaid, Medicare, and the Children’s Health Insurance Program (CHIP).
Disability insurance is another important, yet often-overlooked, coverage that every earner should have. It provides a percentage of replacement income if you’re unable to work due to a disability, illness, or accident.
Remember that health insurance only pays a portion of your medical bills; it doesn’t pay for living expenses, like housing or food, if you can’t earn money for an extended period. If you don’t have disability through work (or you do but it’s not sufficient), purchase a policy and have enough emergency money set aside to tide you over until coverage begins.
See also: 10 Financial Products to Make Money and Create Security
Life insurance is critical when your death would create a financial hardship for those you leave behind, such as a spouse or children. It can help put kids through college, pay off debt, or just provide daily living expenses.
There are different types of policies, but the most common and least expensive option is term life. It gives one or more of your beneficiaries a cash benefit if you die during a set period, such as 10 or 20 years.
If you don’t have life insurance through work, or if you do but it isn’t enough, figure out how much you need. A great place to start is the How Much Life Insurance Do I Need? Calculator at Bankrate.com.
Auto insurance is a collection of coverages that protect you and other drivers in your household. A minimum amount of liability is required by most states because it pays for your legal obligations if you damage someone’s property or injure them in an accident.
However, in many cases having the minimum liability limit isn’t enough to cover the total value of all your assets if you were involved in a lawsuit. So, review your coverage and use your extra income to boost your coverage when needed.
See also: 3 Facts About Usage-Based Car Insurance That Can Save Money
Homeowners insurance is a requirement when you have a mortgage. It covers the structure of your home and your personal belongings anywhere in the world up to certain limits.
Renters insurance isn’t a requirement, but it’s one of the best financial safety nets you can have.
But just like with auto insurance, the liability portion may not be high enough to protect you. It would pay legal or medical expenses if a guest is injured on your property or if you hurt someone off premises and get into a lawsuit.
Renters insurance isn’t a requirement, but it’s one of the best financial safety nets you can have. Not only does it cover your personal belongings up to certain limits anywhere in the world, but you also get liability coverage if someone gets hurt in your rental or you hurt someone off premises. The average annual cost is just $188 per year—that’s an insurance bargain.
You work hard to build wealth and have a comfortable life, so remember to protect it from tragedies—like accidents, illness, natural disasters, and theft—by reviewing your insurance needs each year and boosting coverage when needed.
See also: Your Guide to Renters Insurance
3. Increase retirement account contributions at work
After you’re prepared for the unexpected by having emergency savings and insurance, the next strategy to manage your extra income wisely is to boost your retirement account.
You already know that contributing to your 401k, 403b, or 457 retirement plan at work is a good idea—especially if you’re getting additional free matching funds from your employer. If your contributions are set as a percentage of income, you’ll automatically save more, and get more matching, as your income goes up.
But if your retirement contribution is a flat dollar amount, such as $50 per paycheck, it won’t increase unless you make a manual change online or through your benefits administrator. Getting a pay raise is the perfect time to kick up your contribution.
If you make $50,000 per year and get a 3% raise, you’ll earn an additional $1,500. That’s an extra $125 per month before taxes. If you contribute just that amount every month for 30 years to a traditional retirement account with an average 6% return, it will grow to over $125,000.
Increase your contribution each pay raise until you’re setting aside a minimum of 10% to 15% of your gross income. For 2017, you can contribute up to $18,000, or $24,000 if you’re over age 50, to a workplace retirement plan.
The trick is to act as soon as you get more income so you’re never tempted to spend it. You’re already used to living on less, so saving your extra income won’t feel like a pinch.
The trick is to act as soon as you get more income so you’re never tempted to spend it. You’re already used to living on less, so saving your extra income won’t feel like a pinch.
With a $50,000 salary, investing 15% for several decades would give you over $625,000 to spend in retirement, on top of your Social Security retirement benefit. Imagine the effect of investing 15% of your income as you earn more through promotions, raises, or bonuses.
Some investment companies give you the option to increase your 401k contribution rate by 1% at the start of each year. The more you automate investing the more likely you are to succeed, so I certainly recommend putting it on autopilot.
See also: 7 Pros and Cons of Investing in a 401k Retirement Plan at Work
4. Fund an Individual Retirement Arrangement or IRA
If you don’t have a workplace retirement account—or you do, but have maxed it out—invest through an a traditional or Roth IRA when you have extra income. The money-saving tax benefits are comparable to a traditional or Roth 401k or 403b, so they stretch your dollar.
But with an IRA, the annual contribution limits are lower, aren’t necessarily automatic, and don’t come with free matching, which is why I recommend maxing out a workplace plan first, if it’s an option. For 2017, you can contribute up to $5,500, or $6,500 if you’re over age 50, to either a traditional IRA, a Roth IRA, or a combination of both types of account.
However, if you or your spouse have an employer retirement plan and you also contribute to a traditional IRA, the tax break you get for your IRA contributions may be limited depending on how much you earn and your tax filing status. But there’s no limitation on tax benefits for a Roth IRA when you also have a workplace plan.
Not everyone qualifies for a Roth IRA because they come will annual income limits. For 2017, if you earn more than $118,000 as a single or $186,000 as a joint taxpayer, you may not be able to take full advantage of a Roth IRA.
See also: 10 IRA Facts Everyone Should Know
5. Pay down expensive debt
After you’ve got some emergency savings to cover your back, enough insurance in place, and you’re making regular contributions (even if they’re small amounts) to a retirement account, you’re ready to use your extra income to pay down your most expensive, high-interest debts. These might include payday loans, credit cards, or car loans that have a 10% annual percentage rate (APR) or higher.
In general, it’s best to tackle your highest-rate debt first because it’s costing you the most in interest. However, if you have a small, lower-rate loan that you’re anxious to be finished with, that’s okay too.
Leave low-rate debts, like mortgages and student loans, for last because they’re relatively inexpensive and come with a tax deduction on some or all the interest you pay, which makes them cost even less on an after-tax basis.
Leave low-rate debts, like mortgages and student loans, for last because they’re relatively inexpensive and come with a tax deduction on some or all the interest you pay, which makes them cost even less on an after-tax basis.
See also: Pay Lower Interest Rates on Debt and Save Money
6. Set money aside for your dreams
If you’ve got a handle on your savings, retirement, and debt, use extra income to fund your dreams. Maybe you’ve got your heart set on traveling the world, giving to a worthy charity, starting a business, or going back to school.
Use these six recommendations as a framework to set your financial priorities and come up with a wise plan—but there’s no rule that you can’t accomplish all of them.
Revisit Your Budget After a Pay Raise
After a pay raise, take time to analyze your spending, create a budget, and find categories to cut back so you can boost short-term savings, retirement contributions, and whittle down debt, even in small amounts at the same time.
One popular budgeting approach is called the 50/30/20 rule. It’s a basic guideline for setting limits on your living expenses, variable expenses, and savings.
With the 50/30/20 rule, you spend no more than 50% of your net income on necessities and fixed expenses, such as housing, utilities, insurance, groceries, transportation, and debt payments. You limit variable, discretionary expenses (that enhance your lifestyle, but aren’t necessities) like dining out, clothes shopping, cable TV, travel, and gifts to 30% of your take-home pay.
And the remaining 20% is for financial goals like building your emergency fund, making retirement contributions, and paying down debt ahead of schedule. While these are ideal rules of thumb, you can change the percentages to work for your situation. Only you know what’s a necessity and what isn’t.
The key to building wealth is to maintain reasonable expenses, while increasing your income year after year. That gives you an increasing amount of discretionary income to save, invest, and enjoy life.
The bottom line is that having more income and cash flow is fantastic! But if you spend it carelessly, it won’t help you achieve your unique goals or build more security.
If you’re ready for help managing debt, building credit, and reaching big financial goals, check out Laura’s private Facebook Group, Dominate Your Dollars! Request an invitation to join this growing community of like-minded people who want to take their financial lives to the next level.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.