Spending Smart: Mentally Account for Refund
April 15, 2012 (Chicago Tribune) The term "mental accounting" is a bit of academic jargon, but it might be worth knowing because it can explain how you spend your tax refund this year.
To the perfectly logical economic mind, a tax refund check -- averaging nearly $3,000 this year -- is money that comes into household coffers and should be spent like any other income. After all, a dollar is a dollar, regardless of where it came from.
But that's not how humans think.
Even though money can be spent on any category of expenses regardless of where it came from, we use mental accounting. We designate different pots of money for different expenses. Paycheck money is set aside for retirement, kids' college or to pay for summer vacation. That often serves consumers well by keeping them organized and on target to achieve savings goals. Businesses use similarly rigid systems, where money in the travel budget may not be spent to buy a new office photocopier, for example.
But when money comes into our lives suddenly and with no clear destination, such as a tax refund, there's no mental account for it, and it's often viewed as "found money." And what do humans do with found money? We blow it, of course. Tax refund money just doesn't seem to have the same value as money from a paycheck, although it's money that literally should have been in your paycheck.
A cynic might even suggest we accumulate big tax refunds on purpose because in the back of our minds we know we'll use it for fun money.
So, if you want to spend your tax refund wisely, it makes sense to use mental accounting to your advantage and direct dollars into different pots.
Here are examples of how to do that.
--Pay debt. This is an obvious and typical suggestion. But it has an additional element of mental accounting. Many consumers have both cash savings and credit card debt. They treat them as separate mental accounts. But, from a math perspective, it makes no sense to pay 18 percent interest on a credit card balance while saving money at less than 1 percent bank interest. You can actually "make" money by doing the opposite. So, tax refund money will work harder if you pay off debt rather than bank it. Paying off $3,000 in debt at 18 percent can save more than $500 a year.
--Build an emergency fund. If you're free of consumer debt, saving some cash makes sense. You're not stashing cash for no reason. You're designating it for the multitude of life emergencies that you know will come up. When they do, you won't have to charge the expenses on a credit card and pay interest. Many people create not only a rainy-day mental account but a separate bank account, which helps reinforce the notion that this money is to be used only for emergencies.
--Fun. Allocating a certain amount of the refund check to fun and entertainment can make sense -- just as you would from your paycheck or other usual income. If you want to get a little return, consider spending money on something fun that allows you to avoid or delay other expenses. For example, imagine your car is running fine but you're just tired of it and are considering buying a new one. Instead, get your current vehicle professionally detailed and upgrade the stereo system for a few hundred dollars. If those relatively inexpensive improvements satisfy you for another couple years, it will be money well-spent, compared with buying a new car. If buying a fancy coffee maker means you'll skip your daily Starbucks run, the purchase could pay for itself quickly.
And when you're spending on fun stuff, consider spending on experiences, rather than material things. Academic research shows experiences, especially with other people, add much more to our happiness than more stuff does.
If you were gambling in a casino starting with $200, won $800 and then lost it all, how much did you lose? Many people would say $200, but the answer is $1,000. Because of "mental accounting," we don't consider gambling winnings equal to money earned at work. Of course, the dollars are worth the same.
The concept of mental accounting comes from the relatively new area of academic study, behavioral economics, and it was coined by economist Richard Thaler. Here are a few books that explain in plain language similar foibles of consumer behavior.
--"Nudge: Improving Decisions about Health, Wealth, and Happiness" by Richard H. Thaler and Cass R. Sunstein; Penguin, 320 pages ($16)
--"Why Smart People Make Big Money Mistakes and How to Correct Them" by Gary Belsky and Thomas Gilovich; Simon & Schuster, 288 pages ($15)
--"Predictably Irrational: The Hidden Forces That Shape Our Decisions" by Dan Ariely; Harper Perennial, 384 pages ($15.99)
--Smart-spending resources. Sometimes you can spend a little money to save a lot more. You can subscribe to Consumer Reports magazine (consumerreports.org) for one year for $29 as a resource to make better spending decisions. You can subscribe to a resource that rates local services, such as plumbers, auto repair shops and landscapers. You can do so at AngiesList.com, where prices vary by region but average $6 per month, or at Checkbook.org, where you'll pay $34 for two years. To better use coupons, you can subscribe to TheGroceryGame.com, $10 for eight weeks. You have free alternatives to all of these, but sometimes it's worth paying to get superior or easier-to-use information.
--Maintenance and repairs. If you've been delaying home or auto repairs, use tax money to get them done. Pay special attention to repairs that, if undone, might lead to an unnecessary big expense.
--Insurance. During a cash crunch, it's easy for insurance to slip down the list of priorities. But it's fundamental to being financially secure. Especially consider disability insurance and life insurance if you have people who depend on your income.
--Will. If you've been putting off drafting a last will and testament, using tax money to pay a lawyer to complete one can be money well spent and provide peace of mind.
--Energy savers. From energy-efficient light bulbs to attic insulation, some products that save energy will save you money and can pay for themselves quickly.
WHAT NOT TO FRET ABOUT:
Often financial experts will scream about big tax refunds -- about how you're unnecessarily giving Uncle Sam an interest-free loan. They implore you to adjust your W-4 form with your employer so less is taken out. That's all good advice. But if the primary cost of a big refund is losing interest, that holds little sway today with bank interest rates typically below half a percent. Still, if you'll be paying off debt or building savings with that money, you might as well do it throughout the year rather than in a lump sum when you get a tax refund. To better estimate your withholding, use the calculator at the IRS website: http://www.tinyurl.com/IRSwithholding.