There are moments where taking a voluntary pay cut can make you richer, including creating the ability to enter a new field or industry or make a lateral move where you have the opportunity to gain new skills or knowledge. If you are considering taking a voluntary pay cut, here’s what you should know about how a lower pay grade may impact your financial future and how you can prepare.
Impact on Your Social Security Average
Levon L. Galstyan, CPA at Oak View Law Group, said the U.S. Social Security Administration (SSA) calculates your monthly Social Security benefits based on your work and income. An average of 35 years of income is calculated to determine your retirement benefits. The higher your earnings, the more money you will receive each month.
“If you work for a few years at a shallow income level, your average will suffer due to low-earning years,” said Galstyan. “If you stop working or take a pay cut, your benefit payments are likely to decrease.”
No Room for Extra Savings or Investments
A voluntary pay cut can have a dramatic effect on the savings you set aside for emergencies and retirement. Matthew Robbs, founder of Smart Saving Advice, said many people save a percentage of their income for retirement out of every paycheck. Taking a voluntary pay cut means the percentage you put into your retirement investments will likely drop as well.
Robbs uses the example of a person who invests $100 a month. After taking a pay cut, they may be only allowed to invest $90 a month. That $10 loss impacts your retirement fund more than you might imagine.
“Based on 35 years until retirement and a 12% average annual return, you would effectively lose $75,000 in your retirement account,” said Robbs.
Keeping a healthy savings and retirement account are both keys to avoiding a financial crisis and retiring comfortably.
“When you stop investing, your money stops growing, and you risk losing the battle against the historically high inflation rates we’ve recently seen,” said Galstyan.
Potential Credit Score Harm
A voluntary pay cut may, in some cases, lead to potential credit score harm. Overuse of credit cards and failure to pay bills on time, or make full payments on your monthly balance, may lower your credit score.
In turn, Galstyan said having a low credit score may jeopardize some of your long-term financial goals, such as purchasing a home, and make it difficult to maintain financial stability.
More Budget Adjustments
Agreeing to a voluntary pay cut means you will be taking in less money each month. This means making an adjustment to your budget, which is likely already going through a few adjustments in light of the current inflation period, and determining how you will juggle any existing financial expenses like student loan debt or a car payment alongside a pay cut.
What you do not want is for any of these budget adjustments to push you toward living paycheck to paycheck. “This puts you at risk of a financial crisis in the event of a medical emergency, car breakdown or any other financial trouble,” said Galstyan. “Living with a lower salary than you are used to can be stressful as you try to make ends meet.”
How To Prepare for a Pay Cut
If you are considering taking a voluntary pay cut, start looking at your budget now to prepare.
John Li, co-founder and CTO at Fig Loans, recommends sitting down and pulling apart each line of your budget. This will help you determine your minimum income needs, where you can reduce spending and how much you need to bring in each month to live comfortably. If your minimum needs cannot be met, you may need to explore extra ways to earn passive income or quietly start researching and looking for jobs elsewhere.
Galstyan said those with excess income that have saved more than their target goal and do not have anyone financially reliant on them may be able to accept a lower salary to work in a job that they love.
“Accepting a pay cut can enable you to negotiate for reduced or more flexible working hours,” said Galstyan. “You may be willing to give up a percentage of your income to spend more time with friends and family or give more time towards a personal project or hobby.”
If you are the family breadwinner and you worry a reduced income will make it difficult to make ends meet, you may want to reconsider taking a voluntary pay cut.
“Loyalty is important, but you should always look out for your own and your family’s well-being without feeling guilty. If you have another opportunity, do not let it slip through your fingers and settle for less pay,” said Galstyan.
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