Financial advice when you get a raise

One of the best pieces of financial advice I ever got was to pretend you didn't get a raise, and send the increment to your retirement or long-term investing or to accelerate debt repayment.

Simply wait until your first paycheck with the new amount and see how much higher the take-home is. Set up an automatic deposit or transfer of that amount into your long term investment.

The theory is that you are used to living without that money. So, why pocket it? Instead, put it towards something that will help you in the long term. Most people put off saving for retirement until it is too late, or think that they can't save for retirement. They end up in their 50s or 60s realizing they should have started a long, long, time ago. The reality is that if you start saving a little bit of money each paycheck, just $20 to start, you won't miss it now, and in the future you'll be surprised at how much it has grown.

You were saving nothing towards retirement before, now you are saving something. Something is more than nothing. The way compound interest works, a little something early on turns into a lot of money in the future.

The money you invest in long-term savings often doubles every 10-15 years That is, save $100 now, and in 14 years (assuming 5 percent, which is typical for index funds) that $100 will be $200. If you do this when you are 25, by the time you retire at 65 that $100 will be about $735... a $635 profit and you did zero work! (Zero work other than ignoring the monthly statements for 40 years!)

I didn't get this advice until I was in my mid-thirties. If I had followed that advice since my very first post-college job, I'd have approximately $150,000 more in my retirement account. I could be retiring a year earlier!

If I had gotten the advice when I was first in the job market, I probably wouldn't have followed it. I was living paycheck-to-paycheck as the tech industry wasn't paying sysadmins much back then. However, if I had taken a few steps (brown-bagging my lunch instead of eating out every day), I could have set aside $100 each month easily. That would have been 120 additional $100 payments, each gathering compound interest for 30-40 years.

Let me check my privilege for a moment and acknowledge that not everyone can do this technique. A lot of people are struggling to make ends meet and that raise is much-needed for current expenses. This is especially true if you are just starting a new family or have other large expenses. When I was living paycheck-to-paycheck that was because I had a spending problem, not an earning problem. Believe you me they are way different.

So, where should you put this new money that you are pretending you don't have?

If you are in debt, put it towards paying off that debt. Do this for consumer and high-interests debt (credit cards, student loans, and so on) but not necessarily for your home mortgate. (Why not your home mortgage?) Make it the "extra amount" you add to the highest interest rate debt you have. Suppose that's an 23% interest rate credit card with a monthly minimum payment of $200, and your raise is an additional $50 per month. Pay $250 each month until that debt is gone. Now the debt that has the highest interest rate (was the second highest) should be your target. Suppose it has a $100 monthly minimum payment. You can now lump that $250 as the extra amount for that debt, for a monthly payment of $350. Continue doing this until all your consumer debt is paid off and then live a debt-free life. This technique is called "snowballing" because the "extra" amount grows like a snowball rolling down a hill. When you are debt-free, take advantage of the fact that you are used to living without that amount just like you do with a raise.

If you are not in debt, increase your 401k contributions. This year the most you can put into your 401k in 2018 is $18,500 (or $24,500 if you are over 50 (more if you . That is $1542 per month if you are paid monthly, $771 if you are paid twice a month, or $356 if you are paid weekly. If your 401k plan requires you to specify a percentage, not a dollar amount, talk with your payroll department. They'll do the math for you to figure out the right percent.

Most 401k programs match up to a certain amount. Suppose your employer matches the first 2 percent of your salary. (I assure you your matching plan is different, but this amount makes my math easy.) If you put 4 percent of your salary into your 401k, you'll see the equivalent of 6 percent going into your account each month. Ify ou contribute less than 2 percent, you are leaving money on the table. My advice? Don't let your employer keep that money! If a contribution of that size will mean you'll have to eat out less, make your coffee instead of going to Starbucks every day, etc. its probably worth it.

An interesting tidbit about 401k's: The matching is based on the percentage not on the dollar amount. Suppose Mary and Sally both max out their 401k by contributing $18,500 every year. If Mary makes $100k, that 2 percent match is $2,000. Sally makes $150k, so her match is $3000/year. People that make more money get more matching in absolute terms. It is yet another way that people that perks for wealthy people are everywhere.

If you have maxed out your 401k, then put the increment into a mutual fund or other long-term investment.

I am not a financial advisor, so you should not take financial advice from me. Consult a professional. That said, I like the mutual funds that are named after the year you plan on retiring, like the VTTSX - Vanguard Target Retirement 2060 Fund which does the right thing for a typical person who plans on retiring around the year 2060. (If you want more risk, choose a later year, if you want less risk, choose an earlier year.)

Normally what a financial advisor does is set you up with a diverse mix of funds that are at the right risk/reward ratio for your comfort. The typical investor can handle more risk when they are young, and less risk when they are closer to retirement. They'll "rebalance" you every year to reflect that you are closer to retirement. Therefore, some very smart people realized that they could make mutual funds that do exactly that. This eliminates much of what people need financial advisors for. Considering how much an advisor can cost, this is good for people with simple needs.

Obviously if you have more than simple needs (like a lot of dependents, complex investments, multiple homes, you are saving for children's college, and so on) consider an investment advisor. However, until you have one, don't use it as an excuse to not invest at all!

Some random thoughts:

  • Reward yourself. Use the first increment for a nice dinner or something you like. The paperwork to change your 401k witholding will probably take a paycheck or two anyway.
  • If you get a big raise, consider putting half towards a short-term goal like the down payment on a house.
  • Every time you have a major life change (change jobs, buy a house, have a child, etc.) you might have to rethink your snowballing and other monthly financial contributions. It is often a good time to reset.

In summary:

  • Pretend you don't get a raise.
  • Use the additional "increment" in your take-home for long-term investing.
  • First pay off toxic debt, then max your 401k, then retirement accounts.
  • Tom loves "target" mutual funds named after the approximate year you plan on retiring. It is lazy and awesome.

A lot of these ideas are in the book, The Automatic Millionaire by David Bach. Hey, I'm a sysadmin and I automate all my stuff, right? These techniques are about "set it and forget it" investing.

"Don't let the perfect be the enemy of the good." Set up automatic payments and let it roll. You'll forget about it and years later open your account and be surprised at how well you've done.

Posted by Tom Limoncelli in Career Advice

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4 Comments | Leave a comment

"Comments appreciated"

"Let me check my privilage for a moment..."

Get rid of that sentence. Or at least that clause.

Regarding the Snowball Technique you mention, there is a second method, which while it does result in paying more, can be psychologically more satisfying, and that's to put the extra to the lowest balances first to reduce the number of loans. Maybe when down to the last large balances, switch to the highest interest rate version.

There are usually arguments about which is 'best', but at least both should be mentioned in a starter article about it.

Regarding the Target Date funds: If you want more (or less) risk than is typical, choose a different date fund. E.g. if you plan on retiring in 2060, choose the 2070 fund if you are comfortable with more risk, or the 2050 fund if you prefer less risk.

Replying to PJH: The main idea is to get the most out of each and every dollar. Why devote space to a non-best practice? People will ignore the best practice for what feels better without any encouragement from our gracious host.

Thanks for the comments, folks! I've updated the article appropriately.

"The main idea is to get the most out of each and every dollar."

I thought the main idea was to get out of debt, and get into the habit of not getting into (more) debt.

"Why devote space to a non-best practice? People will ignore the best practice for what feels better without any encouragement from our gracious host."

Do you want people to actually carry on doing something because they feel they're getting somewhere, or give up because they feel they aren't?

People aren't 'ideal things.' They're imperfect. They're irrational.

Yes, yes, paying off lowest %ages *is* the best thing to do, but if people don't *feel* they're actually getting somewhere with their debts (because they still have a lot of different ones - and the highest % debt is going to take ages to get rid of to reduce that number,) then what's the impetus for the irrational to carry on trying to get rid of them? They might as well keep on getting into more debt!

If you want to rail against 'non-best practice,' the original one here was getting into debt in the first place.

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