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Are You a Victim of Lifestyle Inflation?

In the personal finance world, you hear about lifestyle inflation [1] all the time. You should figure that if you were making it on your old salary, most if not all of a raise should go to savings/investments.

Instead, those who are victims of lifestyle inflation find their “needs” creeping up right along with their paycheck [2]. You might think you’re not prone to this problem – I was sure I wasn’t.

Then, on a whim, I looked up my payroll history. From the first year I started my job to now (nearly four years), my twice-monthly paycheck has gone up about $350. That’s $700 per month!

To be fair, that’s pre-tax. But even after taxes [3], and accounting for an increased 401(k) contribution and rises in health insurance [4] and other deductions, my take-home pay has risen just over $450 per month. Since inflation has been mostly non-existent during that time, I should have been able to keep my spending relatively flat, and instead increase my savings by an equivalent amount. Needless to say, that didn’t quite happen.

Where Did it Go?

As part of the analysis of my 2010 spending [5], I tried to figure out where my expenses had increased. Some areas were unavoidable – I live in a high rent area, and rent increases at a rate equal to or greater than my raises.

But in other areas, I definitely am guilty of spending more because I had more. I’d say I allow myself to spend more on both food and clothing than I did 3 years ago. As I earn more vacation days at work and family members/friends experience milestones, I have traveled home more in the last 1-2 years than I did when I first started working.

In addition, as I have gotten older I have had friends from college get married in different parts of the country – three weddings [6] in the last year and at least two in 2011 all come with costs [7] that I didn’t incur in years prior to 2010.

Dialing Back the Impact

While I have not always been great about saving amounts equal to increases in my paycheck, I have been better about saving any “extra” funds I receive, including side income, tax refunds [8], and bonuses.

So my actual expenses may not have gone up too much, and I am at least reducing the impacts of any lifestyle inflation that has taken place. In addition, I’ve tried to cut costs in some categories (such as by moving [9] to a cheaper apartment [10] that included utilities) to make up for increases in other categories (such as transportation, due to major public transportation fare increases). I also remind myself that some amount of additional spending [11] is okay as long as I am still meeting both my short- and long-term savings goals.

Going Forward

I’ll be up for another raise this summer and plan to be quite aware of what I do with those funds. As I have with every raise, I’ll increase my retirement contributions – while my 401(k) contribution will stay the same as a percentage of my check, the dollar amount will go up. I’ll also increase the dollar amount I contribute to my Roth IRA [12]. In addition, I plan to up my cash savings to help me prepare for some potential big outlays in the coming months and years.

Even if you haven’t gotten a raise recently and don’t expect one anytime soon, you might find that you have been a victim of lifestyle inflation. Your paycheck likely went up in 2009 with the Making Work Pay credit [13], and will increase again with the new payroll tax cut [2]. If you can’t account for the increase, you likely just absorbed it into your every day spending.

The next time you see an increase in your paycheck, figure out exactly what the take-home dollar amount is. Then do your best to assign every dollar to a purpose – and try to assign at least 75% of the total raise to debt repayment, savings or retirement contributions. It’s ok to use the other 25% for increased expenses or just a little mad money – just don’t go overboard!

Are you prone to lifestyle inflation? What are some ways you’ll try to combat it in 2011?