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Dear Penny: I’m finally getting a raise. What’s the best way to spend it?

The options the writer offers are all good ones, but one stands out above the rest, the advice columnist says.
[Getty Images]
[Getty Images] [ VGAJIC | Getty Images ]
Published Mar. 9, 2020

Dear Penny,

My company just lifted a pay freeze, and now I’m getting a $4,000 raise. Yay!

I don’t have much savings, and I’m living paycheck to paycheck. I also have about $3,000 of credit card debt. What is the wisest thing I can do with this pay raise?

I’m contributing to my 401(k), but I’m only contributing enough to get my employer’s match and I know I’m behind on retirement savings. Should I increase my 401(k) contribution or use my raise in another way?

-S.

Dear S.,

I want you to think of this $4,000 raise as your ticket out of the paycheck-to-paycheck life.

Increasing your 401(k) contribution is a good long-term goal, but it isn’t the most important priority because you’re already getting all the free money you can out of your employer.

The best way to milk this raise is to use every cent you have left over after taxes to wipe out your credit card debt.

Think about it: The average credit card interest rate is over 17%, whereas many financial planners suggest aiming for average annual returns of 5 to 8 percent for your 401(k). It doesn’t make sense to invest with the goal of earning 8 percent a year when you’re paying 17 percent interest on a credit card.

The first thing you need to do is review your past billing statements so you have a clear sense of when you’ve turned to your credit cards. Is your balance the result of an unexpected expense or two? Or are you regularly using credit cards for recurring expenses?

If it’s the latter, you should rework your budget and look for areas to cut back. But sometimes there really is no fat to cut. If that’s the case, you may need to work part of your raise into the budget. The goal here is making sure you don’t need to revert to your credit card.

On that note, it may be worth funneling a couple months’ worth of your raise into a savings account before you start attacking those credit cards in full force. That way, you have cash on hand for an emergency expense that you might otherwise put on a credit card.

Having a decent amount of cash in the bank can also protect your retirement savings, because you really don’t want to touch that money early. You’ll typically pay a 10 percent penalty plus ordinary income tax if you withdraw money before you’re 59 ½.

You may pay a little more in credit card interest as a result of carrying the balance a little longer, but that’s okay. It’s a small price to pay if it makes you less dependent on credit.

Fortunately, $3,000 isn’t an insurmountable level of credit card debt. So I think with an extra $4,000 a year, minus taxes, you should be able to tackle the balance pretty quickly.

Once you’ve paid off the balance, turn your focus back to that emergency fund. Put whatever you were spending on credit card payments in the fund. Aim to save at least three months’ worth of expenses.

After you’ve paid off your credit cards and you’re prepared for an emergency, you’ll be in a good position to start building the healthy retirement fund you want.

But before you head to HR to change your withholdings, take a step back. Your 401(k) may not be the best place to put your retirement savings above your employer’s match.

Funding a Roth IRA is often a better option than increasing your 401(k) contributions above what your employer matches, provided your income is within the 2020 limits. A Roth IRA gives you a tax-free source of income when you retire because you don’t deduct your contributions upfront.

It’s also more flexible than a 401(k). For example, you can withdraw the money you’ve contributed at any time without paying taxes or a penalty. In 2020, you can contribute up to $6,000 in a Roth IRA if you’re under 50 or $7,000 if you’re 50 or older.

Hopefully, you have many more raises in your future. Now is the time to start planning how you’ll use them. Think about your long-term goals. For example, maybe you’ll want to use the next one to build a down payment fund or save for a child’s college fund. By having a plan now, you’ll avoid the temptations of lifestyle inflation — and you’ll actually have something to show for those hard-earned raises.

Robin Hartill is a senior editor at The Penny Hoarder and the voice behind Dear Penny. Send your tricky money questions to AskPenny@thepennyhoarder.com.