Why you must not consider tax refund as free money

"Let's go to Goa," I told her, as soon as she entered my room with a view, overlooking the bus depot.

The Abba song money, money, money, was playing in the background.

"Suddenly feeling rich are we?" she asked. "You know going to Goa is an expensive proposition."

"Perhaps."

"Out with it."

"So, this income tax refund which was stuck for a couple of years has come through."

"Interesting," she said. "But tell me something V. Given that you plan your finances well, why do you end up with income tax refunds every year."

"As a freelancer, I have no idea about the kind of money I am going to end up earning by the end of the year."

"Hmmm."

"When one pays advance tax four times a year, one is estimating the kind of money one might end up earning by the end of the year."

"And in the process, you end up paying more. In other words, it also means you usually overestimate the kind of money you will end up making by the end of the year."

"Yes, I guess that's true. Also, while paying advance tax, most of the calculations happen mentally and I end up paying big round numbers."

"Okay. Makes sense. Basically, for all the methods you advocate others to follow, when it comes to personal finance, you don't follow them yourself."

"That's partly true. If life was only about methods, it would be so boring," I protested. "But you are exaggerating here."

"So, why do you suddenly want to go to Goa now?" she asked.

"Oh, Goa is loveliest during the rains. Also, it is cheap and has fewer tourists. And most importantly, because I have got a huge refund."

"So?"

"It's basically money that I had more or less written off and it's come back. So, it's free money, which I want to spend."

"You know V," she said, "for all the personal finance you keep teaching me, sometimes you can be quite naive."

"Naive?"

"Exactly."

"But why?" I asked.

"Well, you remember sometime back, you taught me this concept of mental accounts."

"Yes. What about that?"

"Human beings treat each rupee differently from the other and allocate them to different mental accounts, with each account having a different significance."

"Where are you going with this?" I asked.

"Have some patience V."

"Hmmm."

"Like in your case, you have clearly placed the tax refund into a free money account mentally and are ready to spend all of it."

"Hmmm."

"But what is a refund after all? It is basically a deferred payment of your income. Income, which in the normal scheme of things, should have continued to be with you, but due to some reason ended up as excess tax, with the tax department and has now been returned to you."

"Now that you've put it that way, it tends to make sense."

"Given this, you should treat this refund as a normal income and do what you would normally do with it," she said.

"Makes sense," I replied. "I guess some of my income tax refund needs to move from the free money account to the investment account. The remaining can stay in my spending account and we can still go to Goa. Of course, this holiday will be nowhere as extravagant as the one I was originally planning, until you came and explained mental accounting to me, all over again."

"Tell you what V, I have also got an income tax refund."

"So?"

"Well, some of the refund can go into the investment account. The remaining can go into the spending account."

"So?" I asked again.

"Sometimes, you can be quite dumb."

"Hmmm."

"So, between you and me, we have enough money to go on that extravagant holiday that you were originally planning."

"Really?"

"Of course."

"Goa, here we come."

The example is hypothetical.

Vivek Kaul is the author of the Easy Money trilogy.