What should you do with your money when you get a raise?

With year-over-year inflation at a rate of 7.9% — the highest it's been in nearly 40 years — employees are asking for raises from their employers in order to deal with the higher cost of living, which has affected everything from gas prices to groceries. A tight labor market and the Great Resignation has resulted in nearly 47 million workers leaving their jobs in 2021; now workers are requesting more from their employers, whether in the form of additional money and other desired benefits.

That said, the raises employers are giving their workers are often not on par with inflation. While a 2022 JobList survey found that 53% of employees had received a raise, it also showed that more than half (58%) of them had only received a raise of less than 5%.

Though it may be exciting to be rewarded with a higher paycheck, it's important to plan how you're going to allocate the extra money if you're not spending it on higher living expenses.

Select spoke with Barbara Ginty CFP®, certified financial planner and host of the Future Rich Podcast, about how people can figure out what to do with their money after they get a raise.

What you choose to do with your raise depends on the financial goals you had before you received it. If you find yourself spending more money on your grocery bills or on a new car you just purchased, the effects of inflation might end up wiping out your raise. 

If your raise is greater than the effects of inflation, Ginty suggests that her clients split up their raise, saving half for the future and using the other half for current needs and wants. 

For example, if you receive a raise of 8%, make sure 4% of your paycheck is automatically allocated toward your retirement account and keep the use the other 4% for day-to-day purchases.

Save for retirement

If you haven't already, make sure you're contributing to your 401(k) and taking advantage of your employer's 401(k) match. If you've already met the match you can increase your 401(k) contributions or put more money into your traditional IRA or Roth IRA, both of which offer unique tax advantages. With a Roth IRA individuals pay taxes on their upfront contributions; these contributions grow tax-free and can be withdrawn tax-free once you hit age 59 and a half. A Roth IRA is a good option for those who anticipate being in a higher tax bracket later in life, as they won't pay any taxes on withdrawals and gains.

Select ranked Charles Schwab, Fidelity Investments, Vanguard and Betterment as offering some of the best traditional and Roth IRAs. 

Pay down debt

If you do have debt (especially debt with a high interest rate), however, you should prioritize paying that off before focusing on investing in retirement, explains Ginty, as debt often carries interest charges that can quickly rack up.

There are several different methods for paying down debt, and two of the most popular are the snowball and avalanche methods. With the snowball method, people focus on paying off the smallest amount of debt they have first, working their way toward the highest amount. On the other hand, people using the avalanche method focus on paying the debt with the highest APR first. While the snowball method will end up costing you more in the long run than the avalanche method, those motivated by small wins might still prefer it over the avalanche method.

Contribute to an emergency fund

And if you've paid off your debt but you don't have a fully funded emergency fund, consider building one that can cover three-to-six months worth of expenses. You can put your money in a high-yield savings account like Marcus by Goldman Sachs or Ally Online Savings Account.

Avoid lifestyle creep

Ginty warns against people using their raises to dramatically increase their standard of living even when they cannot afford to do so. This is known as lifestyle creep, which is where people find themselves slowly developing a more expensive lifestyle when they get a raise, and often a lifestyle that they may not be able to reasonably afford.

For example, someone may find themselves upgrading to a one-bedroom apartment instead of a studio, even though the studio is more affordable and provides for all their needs. Or someone may choose a more expensive gym membership over the most budget-friendly option. Ginty suggests thinking about what your financial priorities really are and making sure that more expensive purchases fit well within your new budget.

After receiving a raise, make sure you're using it to help fulfill your financial goals, whether that means covering a more expensive monthly rent payment, contributing to an emergency fund or maxing out your Roth IRA for the year. Regardless of where you are financially, you don't want to be using your new salary to fund a lifestyle you can't actually afford.

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