What should I do with my raise?

Congratulations on your raise! (Or cheers to your optimism!)

Most advice on raises sounds something like this:

1. Calculate your new budget
2. Payoff debt
3. Add to your emergency fund
4. Increase your retirement contributions
5. Do something for yourself

This is solid advice if you’re younger and starting out, but if you’re in the midst of your career, it rings a bit hollow. You’re not living paycheck to paycheck and you’re saving enough to be on track for retirement. 

How much of your raise should you save and how much can you spend? 

The Short Answer

You’re not going to like it. You should save at least 50% of your raise. 

Still with me?

Let’s look at an example to help show why this is the case. 

The Impact of Saving Raises

• • Current Income: $250,000
  • Years to Retirement: 25
  • Overall Savings Rate: 20% ($50,000)
  • Investment Assets for Retirement: $415,000
  • Investment Return: 7% 

Fine Print: There are a lot of assumptions in this analysis…linear returns (which are never experienced in reality), no taxes, no fees, that 25 years of spending is the perfect amount for your retirement nest egg, even annual raises, et cetera. Directionally this is informative. Changing a few details will change the magnitude. For instance, if you’re ahead in your savings, then you probably can save less.   

We’ll look at 4 scenarios:

1. Status Quo Without Raises – This illustrates a no raise future where you continue living on the same amount indefinitely. 
2. Continuing 20% Overall Savings Rate – Here we’ll look at maintaining your same saving rate with each raise.
3. Save 100% of Each Raise – This is a lever you can pull if you want to potentially retire earlier.
4. Savings Rate to Maintain Retirement Date – Here we’ll determine the percent of each raise that should be saved to maintain your same retirement date. 

Status Quo Without Raises

This is our baseline scenario. The graph shows the (orange) total amount saved for retirement compared to the (blue) amount needed to retire. The math is that you are spending $200,000 per year and want to spend that for 25 years in retirement for a total of $5,000,000 as your magical financial independence number. 

The bottom line (horizontal axis) illustrates the number of years away or after retirement with target retirement at Year 0. You can see the way your investment compound causes a curve to form rather than a line.

Continuing 20% Overall Savings Rate

Now we’ll look at an annual 5% raise while maintaining the current overall savings rate of 20%. In other words, you spend 80% of your raise and save 20% of it.

What happened? Your annual lifestyle increases outpace your savings. Retirement gets pushed out, but you get to live a little bit more each year! 

Save 100% of Each Raise

If you want to retire or have the option to retire ASAP, savings 100% of each raise will help you. This scenario allows you to retire 4 years earlier! 

Savings Rate to Maintain Retirement Date

Finally, let’s look at how much you need to save to keep your retirement on track with annual 5% raises. 

In this case, the answer is 75%. Ugh. 

It’s like being down at halftime in a game. If you tie in the second half, you lose. You need to score more points to not only win the half but also the full game.

It’s the same thing for savings in your mid-career. If you simply save 50% of your raise, you’re going to be close, but it’s likely to slightly push out your retirement. You have to save more.

Some Good News 

A few things: 

1. This assumes that you’re perpetually increasing your lifestyle. On the one hand, most people at some point stop increasing their regular lifestyle. On the other hand, as you progress in your career, your raises tend to be smaller, and your bonuses tend to have higher potential. This means that
   • • People begin to incorporate one-time big expenses. They’ll throw on a new deck or go on a big vacation. While this means you ARE spending more, you don’t plan on spending that much in retirement. 
     • They have more points that they have a big savings or mortgage paydown year. 
2. The more you have already saved, the further you are from retirement, and the LESS your current savings rate, the less of each raise you need to save. Let me explain the benefit of a lower current savings rate. 
   • • If you’re spending 50% of your $250,000 paycheck, a 5% ($12,500) raise is a 10% increase in spending from $125,000. 
     • If you’re spending 90% of your $250,000 paycheck, that 5% raise only increases your spending by 5.5%.
     • Therefore the impact on your lifestyle is smaller if you save less now. 

Resources

This post is heavily influenced by Nick Maggiulli and Nat Eliason. If you’ve ever had an idea and then found someone that wrote it better than you, you know how I feel about this post. They have some great additional insights if you’re curious for more information.