Six Wise Ways to Spend a Raise
It looks like I'll get a nice raise this year. What's the best way to use the money? Should I use the extra cash to help pay down my mortgage, add it to my retirement savings or do something else with it?
Congratulations on your raise -- and for thinking of the most valuable way to use the money before it starts burning a hole in your pocket. Whenever you get a raise, bonus or other windfall, it's a perfect time to improve your financial situation without having to make any sacrifices. If you've been paying your bills just fine without the extra cash, you can use the money to make some longer-term changes in your financial life.
Your ideas about paying down the mortgage and increasing your retirement savings are great. If you haven't been investing enough money in your 401(k) to get the full employer match, that should be one of your top priorities because it gives you free money that beats out other returns. And it may be better to invest in tax-advantaged retirement plans beyond the employer match, rather than using the extra money to pay down your mortgage, if you have a low interest rate (see more on that decision below). There may be some other good uses of the money, too. The right hierarchy depends on your interest rates and financial situation. Here are six ideas:
1. Pay off high-interest debt. If you carry a credit card balance, you're wasting money every month on interest charges. Devoting the extra money toward finally paying off the bill could save you hundreds of dollars in interest, quickly freeing up more cash for everything else. See Paying the Minimum Will Cost You for more information about how much money you can save by lowering your credit-card debt.
2. Build an emergency fund. It's a good idea to keep three- to six-months' worth of living expenses in an emergency fund, so you don't end up in debt or paying penalties to raid your retirement accounts if you have any unexpected bills or lose your job. Keep the money in a money-market fund or savings account that is accessible and earns some interest. See our Credit Money Management page for the best rates.
3. Add to your retirement savings. If you haven't been investing enough money in your 401(k) to get your employer's full match, then that should be one of your top priorities -- it's free money that beats the return on everything else and makes your raise or bonus even more valuable. And because the money is pretax, it won't lower your paycheck nearly as much as you'd expect. If you're in the 25% tax bracket and get paid $5,000 per month and contribute $500 to your 401(k), your paycheck will only shrink by $375, not the full $500.
If your employer matches your contributions up to 3% of your pay, you'll get an extra $150 per month ($1,800 per year of free money). So you end up contributing $650 per month while only lowering your take-home pay by $375 (totaling $7,800 per year for only $4,500).
Or invest in a Roth IRA. The maximum contribution is $4,000 in 2006 (or $5,000 if age 50 or older) if you're single earning less than $95,000 ($150,000 if married), which grows tax-free for retirement. You can reach the maximum contribution limit for the year by investing a raise of $333 per month.
For more retirement-saving strategies, see How Much Is Enough?
4. Contribute to a flexible-spending account. These accounts, offered through your employer, give you tax-free money to pay for medical expenses for the year. Most employers limit contributions to $3,000 per year, which is $250 per month. Because it's pretax money, it won't lower your paycheck as much as you'd think -- just as with 401(k) contributions. Check out our How Much Should I Put in My Flexible Spending Account? calculator to help figure out the right amount for you.
5. Add the extra money to your mortgage payments. If you have a low interest rate, then there's no big rush to add more money to your mortgage. But over the long run, it will make a difference, helping you pay off your mortgage a few years early and lowering your total interest costs. See Pay Off Mortgage Or Invest? for help making the decision. You can run your numbers through our How Advantageous Are Extra Payments? calculator to see how much of a difference the extra money will make.
6. Use the money to beef up your kids' college fund. Your money will grow tax-free in a 529 account, and you may even get an income-tax deduction for your contribution. See Find the Best 529 Plan for our recommendations.
Got a question? Ask Kim at firstname.lastname@example.org.