Dealing With A Significant Increase In Income

Phil writes in:

I recently switched jobs very suddenly when a spectacular opportunity came a long to double my salary. I’ve been working at my new job for three months and the regular paychecks have started rolling in. I have maxed out my 401(k) at the new job and there is much more being taken out in taxes but I am still bringing home about 75% more than before. What can I do so I’m not tempted to waste it?

Phil has his head on straight – he knows there’s temptation to spend money unwisely when there’s suddenly a lot of money put on your plate. My recommendation for Phil is as follows.

Increase your budget a bit, but not nearly as much as your raise. Let your spending go up a little bit, seriously. You now have a lot more breathing room than before. This doesn’t mean abandon frugality and start buying Dom Perignon by the case, but you should enjoy at least some of this newfound income. If you are bringing home 75% more than you were before, take your old monthly budget and increase the spending by 20% or so in a few areas. This will greatly lessen the temptation to go crazy and still leave you a lot of money to use to take care of business.

Build up an emergency fund. What about that other 55%? Focus on using it responsibly, and for starters, that means building up an emergency fund in a savings account somewhere. My rule of thumb is that for each dependent on your taxes, you should have two to three months worth of budget to save you during a job loss. So, whatever you spend in an average month, multiply that by the number of dependents you have and multiply that by two to see how big your emergency fund should roughly be.

Pay off every debt you have. Once that fund is in place, start paying off all of your debts. Start with the one with the highest interest rate and dump all of that extra 55% into that debt. Then go on to the next one, then the next one, then the next one, until you’re free of all debt. Some people might argue that you should invest at this point, but I have found that for people who have experienced a debt load, the psychological freedom of being out of debt is incredible and well worth it.

Define your goals. Once your debt is entirely paid off (or close to it), spend some time determining what your goals are. Are you interested in starting your own business? Perhaps you want to retire as early as possible. Figure out what your goal is, then identify an investment plan that matches it (if it’s short term, keep it in cash; if it’s long term, put it in a diversified portfolio, for starters).

The key thing is to not drastically change your lifestyle because of an increase in pay. The best way to do this, if at all possible, is to make some financial moves automatic. In Phil’s example, he should see if he can have a certain percentage of his check (about 30%) deposited in a completely separate place from his regular income and then use that money solely to put himself in better long-term financial shape.

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  1. demetri says:

    I might add that he may want to (if eligible still- which he may not be) max out any IRA he and his wife might have.

  2. Johanna says:

    If you can meet your own needs for the present and future and still have money left over, why not donate some of the excess to help those less fortunate than you? (And by that, I mean the billion or so people in the world living in extreme poverty, not just your friends who can’t afford Dom Perignon by the case.)

  3. Danger Dan says:

    How ’bout maxing out on a ROTH IRA? Don’t get tripped-up on what your tax bracket will be in when you retire, just get the $4,000 out of the spending stream. If kids/nieces/godchildren, start a 529 in their name. Good advice on emergency fund and the criteria for each dependant. Might also want to get in the habit of donating to favorite charities and making it annual. If you’re gonna spend, get those 10 CD’s you’ve always wanted in your collection…and listen while sipping that one bottle of Dom Perignon.

  4. dong says:

    Johanna, I’m right with you. I think it’s good to start thinking about giving back once there’s a little excess to give. Giving is as much as habit as anything else.

  5. Margaret says:

    I am dealing with a very large debt load, and I hold off on donating much to “north american” charities, but we have a few sponsor children through various organizations, and I can’t bring myself to cancel those donations. I am still vastly better off than those kids. Even if I were to declare bankruptcy, I would still be better off. I suppose if it got bad enough that we were living on Mr. Noodles and losing our phone service, I would cancel, but we are more the “obnoxious” poor — struggling with debt, but not likely to face serious hardships like hunger or cold.

    What I’d like to know is where to get one of those spectacular job changes!!!

    Also, charitable donations are tax deductible, so for instance, if you donate $1000 a year, you might get back $300 on your taxes (maybe it’s different in the US).

  6. Johanna says:

    How do you get a spectacular job change? Easy: go to grad school for five years. After that, anything is a spectacular job change. :)

  7. Dave says:

    I’d say, set a retirement goal (say, $1 million, which would mean $40,000 per year at a 4% per year withdrawal rate), and save til you get there. Once you achieve that, you are financially free, and you work because you want to, and can tell your boss/company off at any time if they don’t treat you right.

  8. Jim Lippard says:

    demetri: I’d recommend maxing out IRA contributions *even if* you can’t make fully deductible contributions due to your income level. This allows those funds to grow without being taxed, and, under current rules, in 2010 they may be converted into Roth IRAs, with the taxes on the gains to date spread over two years. This is a way for people whose income is too high to allow Roth IRA contributions to end up with Roth IRAs.

  9. doug m says:

    the thing i have seen when some of my close friends get a big raise and such is that they change who they are and start acting differently.

    remember not to ostracize those close to you or else you will be very lonely with your newfound job and salary.

  10. Tim says:

    the first thing to do is to definitely define your short, mid, and long term goals. you will probably be able to attain your goals in a shorter period. That is a good thing. if you are comfortable living on what you use to make, then live that way. if you are meeting your goals, and have extra left, then do some want spending. your goals will drive what you should do with the extra pay.

  11. FIRE Finance says:

    This is an interesting situation. As Johanna says, we would have taken care of our present & future needs which includes daily expenses, retirement savings (401k, IRAs), emergency funds in that order. Next in order would have been debts. Because the first rule to savings is to get rid of all debts.
    Having done this if we still had some money left, we would have given it to charity. We are big supporters of charity and lending a helping hand to the millions who are not so fortunate. But it depends on each person’s priorities about what one wants to do with their extra $. We like to help our fellow souls.

  12. kazari says:

    This happened to me : )

    The first thing we did was set up a high-interest savings account (ING has some good ones) and organise a direct-debit of the difference between my old salary and the new one.
    I didn’t touch it for a couple of months (except for a very nice celebratory dinner, and a couple of classic pieces for my work wardrobe).
    Then, when we were feeling REALLY rich, we started setting some goals for it. 18 months later, we put most of it as a deposit on a house.

    Once we are used to the house repayments, we will split the remaining ‘extra’ funds between extra mortgage repayments, and an index fund.

    Thats whats worked for us. We do donate regularly to charity (time as well as money) and that hasn’t changed appreciably.

  13. Meg says:

    I totally agree with this advice! I recently got a raise (though not a hugely significant one), and I think it’s really important to give yourself a little extra spending money in addition to increasing your savings and accelerating any debt repayments. The whole point of working hard and earning money is to enjoy it! Increase your savings, but don’t beat yourself up for wanting to increase the “fun money” portion of your budget as well.

  14. Adam Lehman says:

    simple dollar

    i’m a college student who is looking for some free software to manage my various accounts (savings, checking, etc.) and a place to track my daily spending. I am currently using an excel doc, but do you know of anything better?

    you could write a post about it or reply. I read all your stuff.

    Adam

  15. Heather says:

    I don’t agree that you should invest in a non-deductible IRA. Yes it will grow tax-free, but your withdrawals are taxed as ordinary income whereas if you invest in stock mutual funds in a taxable account, your withdrawals can qualify for low capital gains tax rates. Start investing outside of your IRA’s! Make it automatic and you won’t miss it.

  16. viola says:

    Get rid of the temptation to spend with direct deposits, and have a plan NOW. Even if you don’t have the money yet, “spend” it on paper. When I say “spend”, I mean allocate the money to things that will buy you assets (investments, house, retirement income, etc).

    My husband & I put a substantial amount of our paycheck into savings & have earmarks for stock investing, real estate investing, future businesses, paying off our house, newer cars soon, etc. etc.

    Also save money for a house (or condo etc)…a big down payment can get you a better interest rate, or better yet you can buy with cash.

    I definitely agree with Trent on giving yourself a little extra cash but keeping the lifestyle close to pre-raise (unless you were so broke you can’t stand living that way). A big mistake people make is that they get a raise, spend more, need a raise and get one, then spend more. It’s a viscous cycle.

    DH & I bought a house we could afford on 1 person’s salary, so when he got laid off, no biggy (well financially at least). When he got a job again, no biggy. The extra just went into savings anyhow & we didn’t see much change in lifestyle.

    Due to DH experience w/ laid off TWICE, job does not equal security. Money in the bank equals security.

  17. DivaJean says:

    The main thing is- make the “extra” money go automatically into whatever savings or investment plan you have- and live the same lifestyle as before the pay increase. Do not have it on hand to fritter away.

  18. KCLau says:

    Why not consider to review your wealth protection plan? When you get a significant pay raise, it means your economic value had increased. Insuring your future earning is definitely the first priority.

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