How to Put Your Pay Raise to Work

[Pam Krueger is the founder of "WealthRamp" and co-host of "MoneyTrack" on PBS. The national spokesperson for The Institute for the Fiduciary Standard, she is a featured columnist for Investopedia. The views expressed by columnists are those of the author and do not necessarily reflect the views of Investopedia.]

My niece, who is 25, mentioned that she just got her first raise and wondered if it was worth adding to her 401(k). That made me realize how important it is to know how you can grow even a small pay increase into an eventual windfall.

Most companies still reward deserving employees by giving them some kind of yearly raise. Sandra McLellan from the consulting firm Willis Towers Watson said recently that employers are forecasting 3% pay increases on average for 2017. That’s similar to last year and the year before and the year before that. McLellan also indicated that top performers may see higher-than-average raises, while low performers may receive below-average increases.

So what does a 3% raise mean to you financially? Let’s put some concrete numbers up to show you how a low-single-digit percentage now can mean big bucks later in life – if you put it to work.

Wealth happens by making your money work as hard for you as you do to earn it. Start with your 3% raise. Just pretend that “extra” money doesn’t even exist. If you have a 401(k) or other qualified retirement plan at work, bump up your contribution by the same dollar amount of your raise (if you aren’t maxing out your contribution already).

If you’re a 30-year-old earning $60,000, a 3% raise will bring you $1,800 per year or $150 per month before taxes, which like having $5 extra a day in your pocket. Not enough money to make a real difference, you say? Pay attention…

To use some real numbers, we'll project our hypothetical 30-year-old back in time 25 years and then see what happens between then and now. Remember that this time period included both some booms and the Great Recession  (2007–2009).

Instead of throwing that “extra money” away, let’s say our saver had invested $150 each month through her qualified plan in the Vanguard Index 500 Fund (VFINX), starting in February 1992. and moving forward to February 2017. That adds up to $45,000 – and that total investment would have ballooned to $143,204. (That math comes from Morningstar Advisor Workstation.) This is an average gain of more than 8% a year and almost 634% on a cumulative basis over the 25 years through the end of January 2017. Still sound like that raise you received wasn’t enough to make a difference?

This is the power of compounding your money, which basically just means that it's generating earnings for you over time. That’s what happened when our 30-year-old put that $150 a month to work in a tax-favored account, a.k.a., a 401(k) or IRA. It was allowed to grow and compound on a tax-deferred basis. We know history is no guarantee of what the future holds, but we realize that over 25 years, the stock market witnessed both historic highs and lows.

Another analysis by Nerd Wallet used a 25-year-old earning a smaller salary of just $45,000 as an example. If she were to receive a 3% pay raise each year until retirement at age 65 and just diverted half of her raise every year into her retirement account, she’d have $223,924 in savings by her 65^th birthday, assuming the money is invested and grows 7.5% on average each year. What makes this a compelling story is that she doesn’t have to lower her standard of living today to wind up with a windfall later.

Let’s say this 25-year-old is able to earn a 5% annual bonus each year, and she invests every dime of it for retirement, along with half of the raise. The payoff is that she winds up with nearly $1 million in retirement savings by age 65.

In addition to investing your raises, consider increasing your contribution to your retirement plan whatever happens. Auto-escalation for your 401(k) contributions is one way to put time on your side. It’s a feature of many plans that lets you specify a percentage of your salary to bump up your contributions in the next year. You have all the control, so you can change the amount or opt out at any time. If your retirement plan offers this feature, don’t hesitate – just use it. It is an easy, painless way to save more for retirement each year.

If your company’s plan doesn’t offer auto-escalation, make a note on your calendar to increase your contribution by a set percentage of salary each year. You could make it the same percentage as your raise or just pick a number you think you can afford. Regardless, just do it.

There’s another tool you can use to help accelerate your savings. It’s automatic deposit, and it is critical. If you’re putting your raise into your 401(k), then this is pretty much a done deal. If you already have an individual IRA or some other type of bank or investment account, you can ask to have this set up for you. It’s just easier to make an automatic deposit than to write out a check each month – or remember to make an online payment.

If you’re a parent (or once you become one) you may want to use the same techniques to fund a tax-favored college savings account. For example, if you were diverting a set amount to cover your child’s college education, perhaps a 529 plan that is designed for college savings is a better option for you. Stop Procrastinating! Enroll in a College Savings Plan can help you think this through. So can College Savings: Why You Should Start Saving Early.

There’s an old investing axiom: “Time in the market is better than timing the market.” That’s because you get the greatest benefit from compounding your investment by doing it over longer periods of time. Even those of us who are well past 30 can still benefit from investing our raises and pretending the money doesn’t exist.

My clever niece was completely on the right track about putting her raise into her 401(k). I'm now confident that she'll be more than comfortable when it’s her time to retire because, at age 25, she’s already figured out one of the most valuable lessons about money.