Lifestyle Inflation can be defined as “an increase in spending when an individual's income goes up. Lifestyle inflation tends to become greater every time an individual gets a raise and can make it difficult to get out of debt, save for retirement or meet other big-picture financial goals. Lifestyle inflation is what causes people to get stuck in a cycle of living paycheck to paycheck where they have just enough money to pay the bills every month.”

As earnings increase, it’s natural to assume that you may want to upgrade aspects of your life (buy a better car or take another vacation),  however, it’s important to remember that if your savings rate isn’t at least keeping up with your rising expenses, you could end up worse off compared to when you earned less.

Derailing Your Finances

The slow creep of lifestyle inflation can have significant long-term implications. When planning for your retirement cost of living, you’ll likely want to maintain your current standard. As your living expenses increase, your savings rate must also increase to accommodate additional income needs in retirement. It seems like a simple concept, but it’s all too often overlooked.

Here’s an example:

Assume you change jobs and earn a $35,000 raise. Your additional annual take-home pay after-tax is about $23,000. You were already maxing out your 401(k), so no other  deductions have changed. Your raise results in a net increase of $1,917 per month, but here’s where it  can go off the rails. Throughout the year, you make some adjustments to your lifestyle:

  • Buy new furniture = $3,000

  • New car = $6,000 down payment + $800 monthly payment ($9,600/year)

  • Increase use of personal services (upgrade gym membership, personal training, spa services) = $100/month ($1,200/year)

  • Eat out more often = $200/month ($2,400/year)

  • Take an unplanned vacation = $4,000

  • Net savings = ($3,200)

Despite earning a $35,000 more, you’ve decreased your bottom line by $3,200! What’s worse, the car is an added ongoing fixed cost taking up 42% of your take-home pay from the raise. So even if you cut back on eating out and vacations next year, unless your income increases, your ability to improve your bottom line is capped.

Running In Place

Lifestyle inflation can affect you, long-term. When you are estimating how much you’ll need to maintain your current standard of living in retirement, you also need to accommodate income needs in retirement. As your living expenses increase, your savings rate must as well.

Avoiding The Inflation

Invest Outside Of Retirement Accounts: A brokerage account is often the best way to supplement retirement savings in a 401(k) or IRA.  Money invested in a brokerage account is available if you needed it (subject to the prevailing  market prices and taxes), but it’s not as accessible as a cash account, which is a feature not a  bug.

Have a Plan: Avoiding Lifestyle Inflation Takes Planning

Without finite attention to your finances, you may inadvertently put yourself in a negative financial position, especially if you unexpectedly lose your job as many have due to Covid-19. Work to balance your short-term wants with long-term needs as you weigh the pros and cons of adding new expenses. Start today to create a plan best suited to your short-term and long-term financial goals.

Jai Ramachandran

Chief Executive Officer