Posted by Mike Smith :: March 27, 2009 @ 9:08 am

One of the strategies that I advocate, saving raises, is a modified version of the pay yourself first technique. In both cases, the idea is to save money before you have a chance to spend it. The logic behind saving raises is simple, but the implementation can be confusing. After receiving a raise this week, I decided to document my thought process to help alleviate some of that confusion.

The main reason why saving raises works so well is that you’re already adjusted to your old income. Saving the raise should have no effect on your standard of living. Even so, you may choose to only save a portion of the raise and allow your spending to increase. It’s only natural to reward yourself for the hard work that earned the raise.

Once you decide how much of your raise to save, the next question becomes how to save it. If you are carrying high-interest debt on a credit card or loan, that’s an excellent place to put your raise to work. Resisting the urge to go out and spend a lot of money can be difficult in light of the apparent windfall a raise brings, but accumulating more debt is the exact opposite of what you want to be doing. Having more money may finally allow you become debt-free.

If you’re looking to bolster your retirement savings, then allocating the savings to your 401(k) or IRAs is a smart move. The general consensus is to contribute to your 401(k) until you’ve maxed out any company matching, then shift contributions to a Roth IRA, and finally use any additional money to increase your 401(k) once the Roth contribution limits are reached. Obviously, your age, goals, and financial situation might make a different approach more ideal.

Once your debt and retirement are both on track, the next place to look might be short-term savings. By building up your emergency fund and other liquid accounts, you’ll be better prepared to handle income disruptions in the future.

A final allocation for a raise can be contributions to your long-term savings and investment accounts. If other areas of your finances are on track, but you haven’t been able to invest as much as you’ve wanted to, a raise is the perfect means to do so. Investing means that you can’t spend the money now, but you can think of investments as deferred spending since growing assets will allow you to spend even more in the future.

Remember that though these steps should generally be done in order, they don’t have to be. If a promising investment opportunity presents itself, you may choose to use your raise towards that, despite having some debt or under-funded retirement and short-term savings accounts. You can also allocate a portion of your raise to all of these steps. With so many people out of work and job security feeling rather weak, it may seem strange to consider getting a raise. Still, being prepared for all scenarios will help you make good decisions, regardless of the one that actually comes to pass.

How would you save a raise you received today?