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What to Do With a Raise

It's one of those oddities of human nature that work expands to fill the time allocated. It can be the same with money and spending. A family living quite comfortably on $50,000 a year can find it all too easy to learn to live just as well on $55,000. How about you? If you were to get a raise, how would you use or spend the extra money? Here are two scenarios.

Couple A
Doug and Kathy, both age 40, live comfortably on their $100,000 joint income. Well, they both received 10% raises this year, increasing their income by $10,000. For the sake of this discussion, let's assume they end up with $6,000 more a year after taxes. That's $500 a month to do with as they please.

Doug and Kathy's first thought was, "How can I spend this money?" They quickly found ways. In fact, it was surprisingly easy. They decided to take an extra vacation this year, a winter cruise. They also decided that they could use a new car. And, as easy as that, there it went, all their money. Now, they're hoping for a good raise next year, since they've actually increased their spending by more than the $500 a month. So, even with their raise, they're living no better — in fact, they are financially worse off — than before.

Couple B
Fred and Mary are also both 40 years old, with joint incomes totaling $100,000. They also receive 10% raises, and, after taxes have been paid, also end up with $6,000 more a year... also to do with as they please.

Their first thought, however, was, "How can I use this money?" Recognizing that their present standard of living and income are nicely balanced, they decided to set this additional money aside for their future. Since they are already living comfortably, they allocated their extra $500 a month to feather their retirement nest.

Their goal is to retire at age 65, or 25 years from now. The chart below shows how their money will grow, based on an average rate of return of 7.5%, compounded monthly:

How $500, deposited monthly, grows, based on 7.5% average return, compounded monthly

AFTER YEAR

TOTAL VALUE

5

$36, 264

10 $88,965
15 $165,556
20 $276,865
25 $438,630

(Table is based on standard tables using Compound Interest & Annuity Tables (McGraw-Hill).This is a hypothetical example intended for illustrative purposes only and is not indicative of the actual performance of any particular product.)

If this money was deposited monthly and allowed to grow in a tax-deferred vehicle, such as an Annuity or IRA, Fred and Mary could have more than $438,000 in additional money waiting for them at retirement. This is money that can supplement their pension and Social Security benefits.

How much money can this nest egg provide in retirement? If it continues to earn 7.5% a year, and Fred and Mary decide they want to withdraw the interest only, they will be able to take $32,897 each year, or $2,741 a month in supplemental income. That still leaves the entire principal amount intact for emergencies or to pass on to their children and grandchildren.

Reminder: This is the money allocated from one year's raise, saved for 25 years. Now let's say that, the second year (age 41), they receive an additional raise, and decide they can afford to save another $3,000 a year — $250 a month — of that money. At that rate, saving $750 a month, by age 65, they could have more than $640,000 waiting for them in retirement.

Once again, this assumes that all money earns an average rate of return of 7.5%. If the rate were even 1% higher, the total amount by age 65 (based on $500 a month for the first year and $750 a month for the next 24 years) would be $750,000, or $110,000 more.

What should you do with your raise this year? Try not to be like our first couple, who frittered it away. And maybe it would be unreasonable to be like our second couple, who saved the entire amount.

Recommendation: Allocate a portion of the "new" money from your next raise to paying off bills and lifestyle enhancement... otherwise known as having fun. Then, especially if your present standard of living is comfortable, send the rest ahead... to help assure that your future lifestyle will be just as comfortable.

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What to Do With a Raise

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