Say you inherited $10,000. Would you use it the same way you use $10,000 you got for weeks of work? How about if you won it in a bet, casino, or found it on the street? If you are more likely to spend easily found/won money because you didn’t work hard for it, you are not alone, and you are subject to a bias called Mental Accounting. You associate different meanings to money depending on the source. But, in reality, all money is the same, no matter how you got it. Specifically:
- If you would save hard earned money, you would rationally save found money.
- If you would spend money you earned on overtime work or a bonus, you would rationally spend the same amount from an inheritance.
Here are some ways to avoid mental accounting:
- Put all money earned, found, won, or inherited into the same account (see exceptions below). Now you can look at it as one pot of money, and forget about its source.
- Put any money that needs to be in a separate account for tax purposes in the account that fits the tax requirements. Examples are:
- Retirement: IRA, Roth IRA, 401k, Roth 401k
- Inherited Retirement: Inherited [Roth] IRA
- Education: Coverdell ESA, 529
- Different Individuals or entities: children, businesses.
- Do not use separate accounts for different goals, unless required for tax- or accounting-purposes. Set priorities for money. Here is one potential ordered hierarchy:
- Set priorities for money. Here is one potential ordered hierarchy:
- Basic necessities, including: rent/mortgage, food, children’s education, cars, etc..
- Children’s education accounts.
- Discretionary (fun/non-critical) spending.