It's nice to have a significant increase in your income. More income means more stability and more opportunities to do the things you love.
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But it also comes with the added responsibility of making the most of your money and building a solid foundation for future financial success.
GOBankingRates spoke with Tyler Weerden, financial planner and founder of Layered Financial, to discuss the best money steps to take if your income increases significantly.
First, figure out how much you actually earn after taxes
“The first thing to do before making any changes to your savings, spending or investments is to figure out exactly what the net effect of that extra income will be,” Weirden says.
“Someone who receives a $50,000 raise and expects to see a $1,923 increase in their salary ($50,000 divided by 26 biweekly paychecks) would be sorely surprised at the actual net increase after taxes and other deductions.”
He said employees should expect federal and state taxes, percentage-based retirement contributions, Social Security and Medicare taxes to all increase as their income increases.
“Before you take any action, you should also consider taxes,” he explained. “If your new income causes your tax rate to go up, could that cause other tax dominoes to fall? Should you make your 401(k) contributions pre-tax (traditional) or after-tax (Roth)?”
He added that other fiscal impacts of higher income include taxes on Social Security benefits, the Medicare Part B Surcharge (IRMAA), the 3.8% net investment income tax, the health insurance marketplace premium tax credit, income-driven student loan repayment plans and other tax credits and deductions.
“Once you have properly understood the net cash flow accretion and tax impacts, follow these steps.”
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Ensure you receive your employer's contributions in your 401(k)
“This free money is the highest guaranteed rate of return anyone can get,” Weirden said.
“Let's say you're a 30-year-old who works until age 60 and your new salary is $150,000. Assume you get a 1% raise each year and your 401(k) investments earn a 7% annual return over 30 years. If you contribute 5% of your salary and your employer contributes 5%, your ending balance will be $1,624,870.”
“Their individual donations over a 30-year period were $260,886,” he explained.
“Without the employer contribution, over the same period and rate of return, you would end up with $812,435. So with the 5% employer contribution, you'll earn an extra $812,435.”
Prepare for emergencies
“A 2024 Bankrate survey found that 44% of Americans say they can't afford a $1,000 emergency expense,” Weirden emphasized.
Building a strong financial foundation with emergency preparedness is beneficial for mental and physical health, he noted.
“It's hard to grow as a person or excel when you're stressed about buying groceries or fixing your car. Money may not buy you happiness, but being financially stable can significantly reduce stress and allow you to focus on other parts of your life that bring you joy.”
“How much do you need in an emergency fund? Most financial experts recommend three to six months' worth, but this may vary depending on your job stability, cash flow, and family situation.”
Enjoy the money you earn
“You shouldn't put your life decisions on a spreadsheet,” Weirden says. “Dying wealthy shouldn't be prioritized over living wealthy.”
“You can always save and invest, but it's not wise to be stingy,” he explained. “If your income increases significantly, don't feel guilty about treating yourself to something you worked for. Take a family trip, buy that pair of shoes you've always wanted. Do something for yourself, big or small.”
'Lifestyle changes' are the real threat to wealth building
Weirden said people tend to spend more as their income increases, reducing the positive effects of increased income.
“But balance is key. If your income increases significantly and you undergo lifestyle changes, you need to increase your savings and investments as well.”
But remember, you don't have to live a completely frugal life.
“You don't have to live like a college student on rice and beans forever.”
Making the Most of Your Roth IRA
“The Roth IRA, originally called the 'American Dream IRA' when it was enacted into law in 1997, is a powerful tool,” Weirden says. “Investments in a Roth IRA grow tax-free and can be withdrawn tax-free after age 59 1/2.”
“Why not max out a Roth 401(k) before a Roth IRA?” he continued. “Flexibility, fees, investment options. Contributions to a Roth IRA can be withdrawn at any time without taxes or penalties.”
He adds that while it's not recommended to withdraw contributions before retirement, in the case of a true emergency where you have no other options, you can withdraw money from a Roth IRA without worrying about taxes or penalties.
“While this is not absolute, Roth IRAs held with low-cost management companies like Vanguard, Fidelity or Schwab tend to have lower fees and more investment options than an employer Roth 401(k).” The Roth IRA contribution limit for 2024 is $7,000, or $8,000 if you're over 50.
If you have excess cash flow, invest more
Weeden said that after reaching the limits of a Roth IRA, investors should consider three investment options: (1) investing in a triple tax-advantaged Health Savings Account (HSA), (2) contributing more to a 401(k), or (3) investing in a simple taxable brokerage account.
“All three of these options have different pros and cons in terms of tax and investment, but none of them is a bad option. Each family's situation, goals and values, health status, tax situation, investor sophistication, personal preferences, liquidity needs and risk profile should all be considered first.”
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This article originally appeared on GOBankingRates.com: I'm a Financial Advisor: 7 Money Moves to Make if Your Income Increases Significantly
