This article was published in Scientific American’s former blog network and reflects the views of the author, not necessarily those of Scientific American
You love getting a tax refund.
What you might not realize is that receiving a tax refund is the result of a forced short-term savings mechanism. At the beginning of each year, you enter into a de-facto savings-club run by the IRS that relies on you overpaying your taxes. You are not alone. In 2015, 83 percent of tax filers received a tax refund, averaging $3,120 per filer.
With over 60 percent of Americans unable to scrape together $500 to cover a financial emergency, receiving a $3,000 annual refund would seem to be another tremendous saving opportunity. Yet, here we are with large tax refunds and little savings.
On supporting science journalism
If you're enjoying this article, consider supporting our award-winning journalism by subscribing. By purchasing a subscription you are helping to ensure the future of impactful stories about the discoveries and ideas shaping our world today.
There are a number of reasons for this: it’s tempting to spend the money once you have it, it’s difficult to route money to savings, and there is little guidance on how much we should save. But the fact remains that setting aside even a small percentage of your tax refund is one of the fastest, easiest ways to fund a savings account.
Here are three ways you can make the most of your tax refund this year.
Pre-Commit to Saving
Most of us wait to find out our tax refund before we plan how much we want to save. From a behavioral standpoint, this is sub-optimal. By the time you find out that you are getting $3,500, the temptation to spend is at its peak. The sirens are already singing.
So what happens when we change the order of operations? Will you save more if you plan your savings before you get your tax refund?
This is exactly what we tested when we partnered with San Francisco fintech startup Digit, that aims to increase short-term savings by automatically withdrawing small amounts of money on a frequent basis from a user’s checking account.
In our control condition, we waited until the tax refund hit their account to ask Digit users what percentage of their tax refund they would like to save.
In our experiment condition, we asked users what percentage of their tax refund they would like to save before they received a tax refund.
In both cases, Digit automatically moved the funds to their Digit accounts.
The results of this simple text were astonishing. Our pre-commitment condition roughly doubled the savings rate to 22 percent from 12 percent in the control condition. This low-cost text intervention helped thousands of people save part of their tax-refund, totaling over $1 million in savings. Moreover, three months after the intervention, roughly 85 percent of the savings were still in the savings accounts.
The One Third Rule
So you’ve pre-committed to saving a portion of your tax refund. Now the question is how much?
This is an incredibly complex and individual question, taking into account how much you have in savings, debt, your own personal goals.
However, if you are starting from scratch and just want guidance, we recommend splitting your tax refund equally across the following three categories:
Allocate ⅓ to savings
Allocate ⅓ to paying down existing debt
Allocate ⅓ to buying experiences that make you happy (in short: treat yourself!)
Mental Accounting and Form 8888
Congratulations. You are officially on the path to savings and improved financial health. But how to turn this decision into action?
Fortunately, the IRS lends a helping hand by allowing tax filers to split their tax refunds across two or three different accounts by filing Form 8888.
Splitting your tax refund into separate accounts leverages the principle of “mental accounting,” which explains why we treat money differently depending on where it came from and where we store it. We think about bonuses differently from salaries and saving accounts different from checking accounts, even though in theory, money is fungible.
Filing Form 8888 is extremely useful if you want to save because it mentally and practically separates your savings from your checking, thereby reducing temptation. Yet, in 2015, less than 0.5 percent of tax filers took advantage of this option!
Be like the smart 1 percent and file Form 8888! It’s a simple to send part of your tax refund directly to your savings account and stick to your savings plans.
What does all this mean for you?
Make a plan before you file and ask yourself what percentage of your tax refund would you like to save (we recommend 33 percent)...Commit to that number. Share it with friends, and if possible, set up an automatic transfer with your bank so that the funds get automatically transferred.
If you have not filed your taxes yet, sign up for our pre-commitment tool to help you save this tax season. While we can’t transfer the funds for you, we’ll send you a reminder, help you commit, and follow up.
Now, go forth, and save. Let April 15th forever be known as National Savings Day!