As you progress in your career, you may well see your earnings increase. Typically, your salary will rise as you become more experienced and possibly achieve promotions. Businesses will increase the wages they offer to keep up with the cost of living too. As a result, you might receive a pay increase from time to time. Depending on the nature of your work, you might receive bonuses or commission. Outside of work, you might receive a small windfall from an inheritance. Knowing what to do with these extra funds can be challenging.
For many people, a pay increase is absorbed into their budget without having a lasting effect on their financial stability or ability to work towards long-term goals.
UK employees take an average of 6 weeks to “level up” their spending habits after receiving a pay rise
If you receive a pay increase, it’s important to be aware of lifestyle creep – the tendency to spend more as your earnings rise.
Research shows this is incredibly common and Actuarial Post reports that UK employees take, on average, six weeks to upgrade their lifestyle after receiving a pay rise. In fact, 17% of those surveyed said they increased their spending immediately.
There isn’t necessarily anything wrong with this. It’s only natural that you’ll want to enjoy a better quality of life as you progress in your career, and it’s fine to reap the rewards of your hard work.
However, if you spend all the additional funds on a more expensive car or eating out at nice restaurants, you could miss opportunities to build wealth for the future. By making conscious choices about how and where you spend the extra wealth, you may be able to make faster progress towards your long-term goals.
That’s why you may want to find a balance between short-term spending and supporting your long-term financial stability.
With that in mind, here are three ways to consider how you spend a pay rise or small windfall.
1. Clear expensive debts
Expensive, high interest debts can make it more challenging to save for the future, because a portion of your disposable income is used up on repayments.
So, if you receive a pay rise, you could use some of the extra monthly income to increase your debt repayments. This could help you clear the debt faster, meaning you free up more income to contribute to savings and investments, or improve your lifestyle. Also, paying off the debt quicker could mean that you pay less in interest overall.
You might consider using a lump sum from a bonus or a small inheritance to clear debts quickly too. Bear in mind that some loans have early repayment charges (ERC) so clearing the balance right away using a lump sum may not be the most suitable choice. It’s important to check the terms of any loans before paying them off.
2. Increase your pension contributions
A pay rise could be a good opportunity to increase your pension contributions and build savings for the future. You benefit from tax relief on your pension contributions, and the wealth is invested on your behalf so it could grow over time.
As a result, a modest increase in your contributions now could make a significant difference to the size of your pension pot in later life.
You may also consider contributing a bonus to your pension, and there are several ways to do this. If your employer offers it as an option, you could use “bonus sacrifice”. This involves giving up some or all your bonus in exchange for pension contributions.
For example, you might sacrifice 50% of the bonus into your pension and receive the rest as a cash payment or pay the full 100% into your pension.
The main benefit of using bonus sacrifice is that your employer pays the funds directly into your pension, and they never form part of your taxable income. This could mean you pay less in National Insurance contributions (NICs) and Income Tax. The contribution is treated in the same way as other employer contributions, so tax relief isn’t required as it isn’t paid in the first place.
Alternatively, if bonus sacrifice isn’t available, you could receive the bonus as a cash payment and then make a personal contribution to your pension. The contribution will then receive tax relief as it’s made from net pay following the deduction of NICs and Income Tax on the bonus.
3. Contribute to savings and investments
You may also want to build wealth outside your pensions by contributing to cash savings or investments.
As your earnings rise and your lifestyle changes, your monthly outgoings could go up. This could mean that your emergency fund won’t go as far as it previously would have done. By increasing contributions to your savings when you receive a pay increase, you can ensure that you have an adequate emergency fund that is suitable for your new lifestyle. It could be easier to save for short- to medium-term goals such as a holiday too.
Once you’ve topped up your cash savings, you might consider investing more of your wealth for the long term. The earlier you invest, the more time you give your wealth to grow, so you may benefit from using a portion of your pay rise to increase your regular contributions to tax-efficient investments like ISAs. Alternatively, you might invest a lump sum from a bonus or small inheritance.
This could make it easier to reach your long-term goals and achieve your desired lifestyle in retirement.
It’s important to remember that if you’re saving and investing in an ISA, you can only contribute up to £20,000 across all your ISAs each year.
Get in touch
If you’re unsure how to use additional funds from a pay rise or a bonus, we can give you guidance.
Email hello@fcadvice.co.uk or call 0333 241 9900.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate tax planning.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts. The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.