Tax refund: It's time for 'mental' accounting

Tax refund is often considered fun money. But a better way to make use of a big tax refund it is to allocate it to various needs and desires. 

Jacquelyn Martin/AP/File
In this January file photo, Tai Sung, a master tax adviser for H&R Block, center, consults with clients about their taxes at his office in Rockville, Md. Instead of blowing your tax refund, try allocating some of it to more responsible uses.

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.

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