Psychology Behind Income Tax Refunds

We have all heard it before.  Maybe you have even said it yourself.  Turbo Tax finishes its job, your CPA gives you the bottom line, your brother-in-law who is good with numbers completes your taxes.  "You owe $324." And what is the reaction?  "Awww Man!  I OWE money?"  We would all rather get than give money, right?  Especially if the party we are dealing with is the IRS.

When we react in that fashion, we are looking at the problem the wrong way.  This year, I received a refund of over $2400.  It was nice to send a sizeable deposit to my brokerage account, but in reality I managed my taxes poorly over the last year.  I was giving Uncle Sam an interest free loan of over $2400 for over a year!  Now, granted, some of it was a shorter term loan, such as the money that was withheld in December, and refunded in February.  However, if we do a Future Value calculation on $200 per month, invested at 4%, I would have had $52.64 in interest.  $52.64 may not sound like much, but it is a nice dinner out (fairly nice, anyway), a tank and a half of gas, or lunch money for a couple of weeks.  Yet, knowing this, when Turbo Tax tells me, "Refund:  $2412", the immediate reaction in me is, "Yippeeee!"

Many well educated, intelligent people react in the same manner.  At least that's what I tell myself.  So, there's a disconnect between what we logically know to be best for us, and how we react emotionally to it.  What is going on here?

Well, there's a branch of economics called, behaviorial finance, that I believe explains some of this.  I touched on this science in my post, "Why is it so Dang Hard to Sell Stocks?"  Part of the theories involve what is called "loss aversion."  That is what is involved in the selling of stocks.

Another part of the theories involve what is know as Mental Accounting.  Essentially we group assets, accounts, or any monies into separate non-interchangeable, or in economics-speak, non-fungible, mental accounts.  In this example we do not view the total amount of our paychecks as being inversely linked to our tax refund.  Instead, we see our paychecks as what they are.  In most cases it is the same amount every other week or twice a month.  This is the basis of the "pay yourself first" method and taking the 401(k) contributions before you see the paycheck.  If you never had it, you won't miss it.  The problem is that Uncle Sam also takes his cut before you see your paycheck.

This problem applies to many more cases than tax refunds.  Inheritances, for example, are often invested differently from most other money.  "This is grandma's money" is what goes on mentally.  This is also why we splurge when we are on vacation in ways that we would never dare in our ordinary lives.

Most of you who would even bother reading a site like this are probably pretty good at recognizing, logically, whether you are making a good decision or not.  However, the important thing to keep in mind is this, a dollar is a dollar is a dollar.  Whether you are in Japan and spending Yen, or keeping grandma's money in t-bills like she always did, or are thrilled at receiving an "extra" two grand from Uncle Sam, don't forget this.  All money is fungible.  Once it is co-mingled, you cannot possibly know which dollar came from where.

Comments

[Financial Freedumb]

That's funny..."Yet, knowing this, when Turbo Tax tells me, "Refund: $2412", the immediate reaction in me is, "Yippeeee!"" So true...This year I owe...and it's a feeling of sadness, when really, I should be happy.

[Tim MMF]

Great post! That's a very interesting perspective.

[Matt]

The withholding rules are structured the way they are for exactly this reason. People get a check from the IRS and they think the government is doing them a favor. But if they had to cough up their tax bill on April 15th instead, they'd be a lot more hesitant to be always screaming for more government spending on the cause du jour.

My "day job" withholding is set as low as it legally can be, and I still end up getting a refund most years, thanks to business expenses and charitable giving. The $6000-ish I got back this year was just another sad reminder of spending over $20,000 in 2005 pursuing a client who ended up going with another vendor. If I'm going to take the loss anyway, I'd rather write it off than not, of course...but still, I'd have been much happier _getting_ that whopper deal and paying taxes on the earnings than I was losing it and taking the cost of my attempts as a write-off.

[empty spaces]

crap.i just realized i have only 10 days to do my taxes for last year and get my refund!

[empty spaces]

how about a link exchange?

[Tomasz]

Yeah - TurboTax helps with tax preparation a lot. It is worth it to pay some cash for it.

[bills]

A tax refund is like getting a gift of your own money. Like you stated before, if it's taken out before you receive you check, you don't miss it.