What (not) to do with your tax refund

Each year, about half the country gets to experience a sudden wealth event in the form of a tax refund. While not necessarily a financial windfall for most, this annual occurrence can create some awfully strange and counterproductive behavior. The average tax refund is about $3,000. This is a nice chunk of money that can be put to good use ... but, if we are to have any hope of using this money wisely, we first have to get out of our own way.

Money is money, right? You know a dollar in your left hand is worth exactly the same as a dollar in your right hand. You know a dollar in your wallet is worth the same as a dollar in your bank account. You also know a dollar that you earned from a hard day at work is worth the same as a dollar you find on the ground. Of course you do, er, well, sort of. And this last one is where our trouble starts.

Regardless of the source of the money, logically we know the value is the same, but somehow a dollar we earn is "worth" more than the dollar we find. Why is that, and what does it have to do with your tax refund? Well, it's because of our tendency to engage in "mental accounting," and this has everything to do with your tax refund.

Mental accounting is a fancy phrase from the fascinating field of behavioral finance -- the study of how we make decisions (often completely irrational ones!) about money -- which describes our tendency to treat money differently depending on its source. A good deal of my work as a sudden wealth adviser is helping clients avoid valuing money they receive from lottery winnings, lawsuits, inheritances or other sudden wealth events as being worth less than money they earn through their labor. The consequences of valuing "found" money differently than "earned" money are dramatic -- individuals are inclined to take more risk with found money, to give it away more freely and to spend it faster and more lavishly.

Even though your tax refund is from earned income, it feels more like found money to most people. The result is that it gets spent quickly and frivolously. The solution is to have a plan for your tax refund before you get it. Here's how you can avoid the mental accounting mindset and use your tax refund wisely:

-- Out of sight, out of mind. The less control you have over your tax refund, the less likely you'll fret it away. Use IRS tax Form 8888 to designate up to three separate accounts for your tax refund to be deposited into. Some of the best places to put it are IRAs, brokerage accounts or directly into your emergency reserve savings account.

-- Take a class. Gaining new skills, earning designations and learning are always good investments. Some of the best returns for your money can come through inexpensive courses/programs offered through local community colleges that provide specific and hands-on practical tools you can use to grow at your current job or that will train you for a better job.

-- Pay down credit card debt. One of the complaints with credit cards is that the swipe of the card doesn't have the same gravitas as pulling out fives and tens and paying for the purchase in cash -- for many it feels like digital Monopoly money. So, what better way to use your less valuable "found" tax refund than to pay off this equally nebulous debt?

Any rational person will tell you that a tax refund is worth just as much as the money in your paycheck, but that's the point. When it comes to money, we're often not rational. We do strange things that make no logical or financial sense, but we do them anyway. You could engage in a series of exercises that connect you with your money, or you could do the much easier thing and simply create a plan for your tax refund before you get it. It might not be as fun as blowing it in Vegas or on a new flat-screen TV, but my guess is that you'd think long and hard about doing this with your next paycheck.

(Robert Pagliarini is a CBS MoneyWatch columnist and the author of "The Other 8 Hours: Maximize Your Free Time to Create New Wealth & Purpose" and the national best-seller "The Six Day Financial Makeover." Visit YourOther8Hours.com.)

Featured Stories

CTnow is using Facebook comments on stories. To comment on ctnow.com articles, sign into Facebook and enter your comment in the field below. Comments will appear in your Facebook News Feed unless you choose otherwise. To report spam or abuse, click the X next to the comment. For guidelines on commenting, click here.