According to research by Payscale.com, most college graduates receive their largest raises early in their careers. This gives young earners a great opportunity to start good financial habits early by increasing their savings rate with each pay increase. Directing all or a large part of a pay raise into a 401(k) or other savings vehicle puts the money aside before new spending habits based on the higher income kick in.
To show you how it works, we’ll use our fictional friends, Sara and Sam, as an example. Both are recent college graduates earning $40,000. Sara and Sam each decide to contribute 3% of their salary to a 401(k) plan in order to take full advantage of the company’s 401(k) matching benefit.
Over the next three years, they receive raises of $2,000 per year. Sara decides to increase her contribution to her 401(k) by half the amount of her pay raise. Sam decides to continue to contribute 3%. Saving half of her raises for three years will increase Sara’s annual contribution to $4200, which is over 9% of her salary. Sam’s annual contribution is $1380.
Sara is also spending less. By not allowing her spending to grow as quickly as her salary, she is avoiding the lifestyle-creep trap that young professionals with rising salaries often fall into.
Furthermore, spending less provides a safety net that will allow Sara to handle unexpected financial hardship. If the economy hits a rough patch and both Sara and Sam are forced to take a 5% pay cut, Sara could save at a lower rate without having to adjust her spending habits. Sam, however, would need to stop saving and spend less just to meet his bills.
In addition to saving for retirement, there are other wise financial options that you may consider when receiving a raise. You could pay off your college loans or save money for a down payment on a home. Paying off debt is always smart, and in many locations, owning your own home is less expensive than renting in the long run. You’ll need to crunch a few numbers to figure out what’s best for your particular circumstance. But one thing is certain: putting the money aside to pay for an expensive car or a boat is not saving. That’s simply delayed consumption.
Bonuses are the ultimate in found money. If you can live on your salary, then saving your bonuses is a painless way to build up your stash. If you’re going to splurge, use only part of the bonus and spend it on something you pay for in full. Don’t use your bonus as a down payment on a luxury item. That could turn what should be a positive financial event into an additional monthly expense.
When you save your raises and slow down the rate at which you increase your spending, you give yourself financial flexibility. If an opportunity to take an unpaid sabbatical becomes available, you could afford it. If, at some point, you would like to change careers, you could take a pay cut to do what you love. Even if you never change jobs, knowing that you could afford to reduces stress. It’s easier to deal with those days when your boss is annoying and the customers are impossible when you know that you have other options.
Saving more and living on less is a double blessing. It allows for more flexibility during your working career and significantly increases the likelihood that you will enjoy a comfortable retirement. It’s worth your while to save that next pay raise—and you deserve it!