Making the Most of Windfall Gains
One of the fundamental truths about personal finance, is the fact that our problems with money have little to do with mathematics.
We know we have to spend less than we earn. We know that credit card debt, with its double digit interest rates, is bad for our long term success. We know that saving for retirement is important and that compound interest is our friend.
We don’t save as much as we should for retirement because we can’t picture ourselves in forty years and needing that growth. We don’t see ourselves spending months to pay down a debt we accrue in just minutes.
It’s not that we’re bad at math, we’re bad at psychology.
As we approach tax season, you will probably get a tax refund. Last year, the average tax refund was nearly three thousand dollars. I don’t care how much money you make, that counts as a windfall. The problem with a windfall like that is that you are not psychologically prepared for it. You have a tendency to see it as a bonus rather than what it really is – an accumulation of last year’s overpayment of taxes.
To hijack your instinct to simply spend this “free” money (that in reality you worked really hard for), put it to work before you get it.
Boost Your Retirement Fund
Right before you file your taxes, you should know how much of a tax refund you’ll get from the Treasury. Use the money to boost your IRA. Better yet, max out your IRA from the beginning of the year to make an extra $705 more.
Pay Down Debt
You can’t build on your net worth if you’re anchored to high interest credit card debt. Pay down expensive consumer debt. Credit card companies absolutely love it when you only pay the minimums because it means they get to keep extracting money from your wallet every single month. Your mind may tell you you’re able to buy a couch and only pay $20 a month, but the math says you’ll still be paying for that couch even after you’ve trashed it.
We can’t always outsmart ourselves and the psychology of money goes way deeper than our conscious minds will admit (it’s why we eat late night snacks even though we know it’s bad for us). Why not give in a little so you don’t give in the whole way? Treat yourself to something nice and then put the rest towards something “responsible”, like paying down debt or saving for your retirement. Depending on the size of your windfall, this could be a nice vacation or just the latest gadget you’ve had your eye on. By treating yourself a little bit, you enjoy the fruits of your labor (or luck) so you don’t feel compelled to blow the whole amount.
Remember that ultimately this is a question not about self control or intelligence, but simple psychology.
Windfalls are tricky to deal with because we don’t think of them as “earnings” or “regular money,” we think about it as a bonus and how we should treat ourselves.
In the end, money is fungible: A dollar from a windfall is no different than a dollar from work or found on the ground. Use those dollars to get closer to your biggest goals. Anything else is a waste.
Answers to Financial Questions with Alex Benke, CFP®
After receiving so many questions from "Better Off" listeners, we decided to devote an episode to answering a few. Alex Benke, CFP®, joined me to tackle a variety of issues, from planning for retirement to paying off student loans.
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