How Should I Use My Tax Return?

| March 04, 2020
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I love finding money. Soon, I’ll be breaking out the shorts from my dresser drawers, and I’m hoping that I left a $20 bill in one of the pockets. It’s unlikely, because I rarely carry cash on me - I can’t miss out on earning travel points! But I do carry cash sometimes, and I’m hoping I stumble across some this spring, because I’ll get a little joy out of finding money that I didn’t know existed. In fact, that’s the reason I enjoy finding money – not because I love money, but because it’s like that money never existed, and now all of a sudden, it does. I now have a $20 bill that I didn’t account for in my budget, and that I can spend on something on a whim without feeling like I need to be responsible with it.

However, the truth is that $20 bill always existed, and it was mine before I found it. I simply forgot about it, and I should be just as responsible with it as I would be if it were just included in my paycheck. So, why do I treat that $20 differently than if it were in my checking account? It’s because of a behavioral finance concept called “mental accounting”. In our minds, we treat different sources of income differently (although technically, that $20 found money isn’t really income, but I digress). Think about it. If you get a cash bonus, do you treat that differently than your regular paycheck? Research shows that yes, you probably do. The same is true for “found money”, like that $20 bill example. Now, if you blow $20 you found in your coat pocket or glove compartment, that’s probably not going to mean the difference between success or failure. But when it comes to larger amounts, treat that money with the same level of consideration as you would a paycheck.

One of the biggest sources of “found money” that can be subject to mental accounting pitfalls is a tax refund. Lots of taxpayers treat their tax return like it’s a bonus, and they blow it on something they regret purchasing. This time of year, you hear a lot of advertisements from car dealerships that encourage you to spend you tax refund on a car. I can’t stand those advertisements because most are borderline predatory, encouraging people to make quick decisions that have big – potentially negative – impacts on their finances. Now, if you genuinely need a new vehicle and you aren’t making an impulse purchase, that might be a good use for your tax return. Other common uses for tax returns are home improvements and vacations. Those things aren’t bad, but don’t just assume that because you got a tax return, you need to make a big purchase.

Before deciding what you do with your tax return, consider adjusting your tax withholding amounts. I won’t get on a soapbox about giving the government a tax-free loan, but that is effectively what happened. If you adjust your withholdings amounts to lessen the amount of tax that is withheld, you’ll see an increase in your net pay, all things equal.

Once you get your withholding figured out, you still have this year’s tax return to address. How should you use it? If you’re a regular blog reader, you hear this all the time: start with your goals. Are you on track for retirement? If not, maybe it would make sense to put that money towards retirement. Are you preparing for a drop in income, and you need to get some debt paid off? Maybe it makes sense to pay down some debt. Do you have any college savings goals for your kids? Consider putting the money in a 529 plan. Not only will that get you closer to your college savings goals, it might also get you a state income tax deduction (talk to your tax professional to confirm).

Your goals don’t have to be all long-term, though. We do invest money for our clients, but that doesn’t mean we’re always telling people to invest. After all, we’re fee-only investment managers and financial planners, so we are obligated to give advice that is in our clients’ best interest. Sometimes buying a car is EXACTLY what someone should do with their tax return. If you’re driving a clunker, living ridiculously frugally, and you’re investing the heck out of your 401(k), maybe you’re overdoing it. Perhaps a new car would be a great use of your money.

However you use the money – whether it’s spending, saving, or giving – do it with intention. Often times, we make the mistake of just spending money because we have it, and don’t really consider the best way to use it. What’s the best way to use it? It’s a complicated question, and if you’re on track to meet all of your goals, consider how some uses affect your level of happiness (you can read about that on a previous blog post here). Research shows some interesting conclusions about how we can use money to increase happiness. Spoiler alert: blowing money on something you don’t actually care about it NOT a good way to improve your happiness.

The point is, all of your spending decisions should be keeping a big-picture, goal-based view in mind – whether it comes from your tax return, gambling winnings, a bonus, or your regular paycheck. Falling victim to mental accounting errors can get you off-track of meeting your goals, and can cause you to make decisions that you might regret.

unsplash-logoKelly Sikkema

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