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The Behavioral Economics of Tax Refunds

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If you were about to get a check for $3,000, what would you do with it? If you've already thought about it, you're not alone. It's tax refund time and two thirds of Americans have received or are anticipating a refund. Last year 119 million Americans received refunds totaling more than $358 billion. So far this year the average tax refund is close to $3,200.

Obviously a large refund means you've overpaid your taxes during the year. Yet only 19 percent of Americans receiving refunds plan to reduce their withholdings. Why?

Some overpay out of fear they'll owe money at tax time. A few are surprised to be getting a refund. But most use Uncle Sam as a savings enforcer. Debt reduction seems more dramatic when it happens all at once, savings feel more meaningful in large chunks and vacations are easier to save for if the money's automatically set aside.

Having money deducted from your paycheck before you can spend it is a tried and true savings method. But with all that technology has brought to banking, it's easier than ever to do it yourself and gain the advantage of making the savings work for you in the meantime.

Here's how Americans plan to use their tax refunds this year, and why they should have withheld less instead.

Spend It

Tanya admits that she looks forward to "splurging" when she gets her refund. "It's always gone before I know it, it seems like so much money -- but after dinner out, a couple bills paid and a little shopping, it's gone." While most people logically understand that a tax refund is simply the return of their own money, emotionally it can feel like a windfall. And windfalls are typically spent more frivolously and extravagantly than hard-earned cash.

Over half of those getting refunds plan to spend it. Stacy is getting a new iPad. "Perfect timing," she says. Rudy is getting his dog's teeth cleaned, and Jay just bought a bigger television. According to a study conducted by BIGresearch for the National Retail Federation, 12 percent plan to use their refunds for a vacation. The same survey finds that 30 percent plan to spend their checks on "everyday expenses" and 13.2 percent on big ticket items like furniture or electronics.

Save It

But 42 percent plan to sock it away. That percentage has been growing since the start of the recession. In 2007, 38 percent planned to save their refund. Savers could have saved even more if they'd been tucking it away (with interest) or investing part of a bigger paycheck all year long.

Pay Down Debt

A "tax refund savings plan" makes the least sense of all for the 42 percent of Americans who plan to use their refunds to pay down debt. "I usually use my tax refund to pay any leftover holiday bills," says Carrie. But if Carrie had withheld less and paid her bills when they arrived, she would have avoided finance charges.

Debt reduction is normally the top pick in annual tax refund surveys. This year the lowest percentage since 2006 are using their refunds to pay off debt. Which might mean that survey-takers are getting more honest. Federal Reserve statistics show that credit debt is typically reduced or slowed around refund time but it's nowhere near the numbers you'd anticipate by the percentage found on previous year's surveys.

BONUS STAT: Wondering if you'll get audited? Last year the IRS examined 1.5 million individual tax returns.

Sources:
IRS 2010 Data Book
National Retail Federation 2011 Tax Survey
Federal Reserve Statistical Release on Consumer Credit
IRS Tax Stats
Bankrate.com 2010 Tax Survey

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