Have you ever spent a tax refund or bonus check so fast your head spins? This article will help you avoid that in the future.
My wife and I used our tax refund last year to buy some new porch furniture. We had bought some used chairs and a table from a friend, but we were ready for something new. The set we had our eyes on at Home Depot was on sale, so we ordered a set for ourselves.
That felt pretty good. It wasn’t an extravagant purchase but we certainly didn’t add to our retirement funds. Which is different than what happened two years ago.
We used our tax refund from two years ago to pay down extra principal on our mortgage. As soon as I got the taxes done, I filed the electronic return with the IRS. A week later, they deposited our refund into our bank account. The day after that I wrote a check to our bank. Poof! The refund was gone.
That felt kind of bad and it’s bothered me ever since. Why does buying something fun with a tax refund (or a bonus check) feel better than being responsible? Why does buying something fun with our bank account feel irresponsible?
Mental Accounting Can Trick You
The answer is something called mental accounting. It’s a fancy way of saying you use your mind to separate money into different accounts. If you have $2,000 in a savings account, you might split it in your mind between emergencies and rent. But you still have $2,000 to your name. It’s your money!
Gamblers also trick themselves with mental accounting. Professors Richard Thaler and Eric Johnson did a study to see if winning money changed how people gamble. When you walk into a casino with money in your pocket, you think of it as your money. When you win money from the casino, you consider it “house money.” The difference causes you to be riskier with the house money than with your own.
Let’s say you walk into a casino with $100 in your right pocket. After putting $50 in a slot machine, you hit a tiny jackpot and win $100. You put the winnings into your left pocket. The right pocket has your original $50 and the left now has $100 of winnings. To keep gambling, which pocket will you take the money from first?
You would probably start gambling with the money in the left pocket because it’s the house money. Once the winnings are gone, you might take your original $50 in the right pocket and go home. Economists have a problem with that choice because the all the money is in your pockets. Right or left shouldn’t matter. But you’re human and mental accounting makes it matter.
Like the gambler, you separate “your money” from sudden windfalls. Year-end bonuses, lottery winnings, and tax refunds have a special place in your mind. To wisely spend the windfalls in your future, there are two steps you can take.
The First Step: Goals
The first step is to have financial goals. Saving for emergencies and paying down debts are great ways to spend your windfalls. Other goals could include a buying a new bed or saving for the next round of holidays. It’s important to rest and refresh yourself, so a vacation might not be bad either.
Your goals are up to you. As I shared earlier, there is an emotional issue to deal with. Although paying down our mortgage was a responsible move, my wife and I felt bad for not having a little bit of fun. And the second step helps to deal with those emotions.
The Second Step: Time
The second step is to hold on to the money for some time. Deposit the money into a savings account with your other money and wait. The trick of mental accounting is separating your money from the bonus money. If you let the money sit in an account long enough, you start to view it in a different way. The euphoria of the windfall dies down and the bonus money transforms into your money.
The more money you get, the longer you should wait. A month is a good minimum. If you win the lottery, you might want to wait a year before you start spending it.
A Quick, Final Note
One quick detour on tax refunds. They are not bonuses. The IRS and other state agencies held on to your money for free and are giving it back to you. If you choose to have fewer taxes deducted from your paycheck, you will have more each month to save or spend. Please be sure to consult with an accountant so you don’t get yourself into trouble.