Each year about half the country gets to experience a "sudden wealth" event in the form of a tax refund. While not necessarily a financial windfall for most, this annual occurrence can create some awfully strange and counterproductive behavior.
The average tax refund is about $3,000. This is a nice chunk of money that can be put to good use. But if we are to have any hope of using this money wisely, we first have to get out of our own way.
Money is money, right? You know a dollar in your left hand is worth exactly the same as a dollar in your right hand. You know a dollar in your wallet is worth the same as a dollar in your bank account. You also know a dollar you earned from a hard day at work is worth the same as a dollar you find on the ground. Of course you do, er, well, sort of. And this last one is where our trouble starts.
Regardless of the source of the money, logically we know the value is the same, but somehow a dollar we earn is "worth" more than the dollar we find. Why is that, and what does it have to do with your tax refund? We can blame our tendency to engage in "mental accounting," and this has everything to do with your tax refund.
Mental accounting is a fancy phrase from the fascinating field of behavioral finance, which is the study of how people make decisions (often completely irrational!) about money. Mental accounting describes our tendency to treat money differently depending on its source. A good deal of my work as a sudden wealth advisor is helping clients avoid valuing money they receive from lottery winnings, lawsuits, inheritances or other sudden wealth events as less than money they earn through their labor.
The consequences of valuing "found" money differently than "earned" money can be dramatic. People are inclined to take more risk with found money, give it away more freely, and spend it faster and more lavishly.
Even though your tax refund is from earned income, to many people it feels more like found money. The result is it gets spent quickly and frivolously. The solution is to have a plan for your tax refund before you get it. Here's how you can avoid the mental accounting mindset and use your tax refund wisely:
- Out of sight, out of mind. The less control you have over your tax refund, the less likely you'll fritter it away. Use IRS tax Form 8888 to designate up to three separate accounts where your refund can be deposited. Some of the best places to put it are IRAs, brokerage accounts or directly into your emergency reserve savings account.
Any rational person will tell you a tax refund is worth just as much as the money in your paycheck, but that's the point. When it comes to money, we're often not rational. We do strange things that make no logical or financial sense. You could engage in a series of exercises that connect you with your money, or you could do the much easier thing and simply create a plan for your tax refund before you get it. It might not be as fun as blowing it in Vegas or on a new flat-screen TV, but my guess is you'd think long and hard about doing this with your next paycheck.