Economists say that mental accounting is a problem.
I'm not so sure.
Last week, I brought up the story of Ray Suarez, journalist who found himself retired sooner than he had planned. He was reluctant to tap into his retirement savings because he figured he’d get another respectable job soon, but that didn’t materialize.
Suarez was engaging in what behavioral economists call “mental accounting”, a concept by which people keep their money in different buckets and don’t mix them. They treat bonuses and windfalls differently than earned income, for example, spending those on fun things rather than allocating them to the household budget the same way that they spend their income. A classic example is over-withholding income taxes to get a large refund to blow on something fun, instead of putting the money into a savings account and earning interest on it.
At the same time, American families must manage their finances in an economy without a lot of safety nets. And one way they do this is through mental accounting. That’s why people might set aside money in a college fund while also having high-interest credit card debt, or why they don’t budget for vacations and instead wait to see what the year-end bonus looks like.
I’m guilty. I overestimate my periodic tax payments: there were a few April 15ths in the past when I was caught short by a big tax bill. It was stressful. And yes, I could optimize by paying the IRS a minimal amount and putting the rest in a savings account, but that calls for a level of organization that I don’t always have. I’m willing to give up interest in exchange for reduced stress.
If our refund is more than a nominal amount, it usually goes toward vacation. Will we go to Cedar Point, or will we go to Europe? Both are fun.
Another issue is that tax policies treat different pots of money differently, for very real policy reasons. There are tax benefits to setting up a 529 college savings plan and participating in a defined-contribution retirement plan. There are tax penalties for spending those funds for other purposes. Suarez was old enough to draw on his retirement accounts, but it wouldn’t be surprising if he had a mental block about it.
If you end up getting a tax refund and have a financial shortfall somewhere, such as high interest debt or underfunded retirement, put the money there first. It’s not free money, if it feels that way. But if you’re in good shape, go ahead and blow it. The behavioral economists don’t have to know.
What do you think?