Embracing Mental Accounting

Planning Reflection | February 25, 2022

Money is fungible – any dollar is functionally indistinguishable from any other dollar – but people do not treat it that way. We subjectively value money based on arbitrary categories, such as the source of the money, the intent for the money, or even the context in which we’re spending it. A bonus feels different from your regular paycheck, and money set aside for a vacation feels different from money earmarked for home maintenance. This phenomenon, known as “mental accounting” in behavioral economics, shapes how we categorize and value money, consciously or not, and influences how we behave and interact with it.[1]

We regularly encounter examples of mental accounting in our work with clients. While it can invisibly (and often irrationally) influence financial decisions, it isn’t inherently good or bad. Becoming more mindful of its impact on our decision-making, can help us harness these natural tendencies to achieve our goals and minimize regret.

Recreating the Paycheck

During their working years, most people pay for expenses primarily from their paycheck, and in fact, they organize their whole budget around the size of their paycheck. Younger people typically don’t have much money beyond what they’ve earned recently, making their paycheck a concrete financial constraint. As they get older and accumulate savings, the habit of relying on their paycheck stays strong even though they have other available resources. When they retire, they stop adding to savings and instead begin drawing from them to fund expenses, reversing a decades-long relationship with those dollars. 
Many people find this transition deeply uncomfortable. One way to navigate it is to establish a “retirement paycheck,” a consistent monthly transfer from their portfolio to their bank account that lands on the first of the month and covers regular spending. The transfer serves a few functions:

  • It feels like a paycheck, mitigating the stress associated with drawing on savings. 
  • It provides a useful anchor point for ongoing spending, offering a way to easily gauge whether your expenses are on track with your plan month-to-month.

Even though a dollar from earnings spends the same as a dollar from savings, creating a structure that acknowledges our hardwired quirks can improve the experience of using retirement savings.

Managing a Windfall

The unexpected receipt of money offers another example of mental accounting in action. A windfall can be small or large, and it can come from gifts, bonuses, lottery winnings, an inheritance, even a tax refund. We tend to treat windfalls differently from income we expect to earn, typically spending more than we would have without it, and often buying things we would not normally have purchased.[2]

For example, you may not typically eat at expensive restaurants, but getting a $50 gift card could entice you to go out and spend $200 on a meal. When you get your year-end bonus, you might decide to treat yourself to a massage with some of your “extra” money. The source of the windfall can also influence people’s willingness to spend it. You might be perfectly happy to pay for a vacation with your tax refund, but not with the stock you inherited from your mother. The experience of a windfall can lead us to make different decisions than we might with other dollars.
The best way to react to a windfall is to slow down. That gives you space to intentionally integrate the money with both your emotional responses and with your existing plans. If you’re focused on debt reduction, you might commit to paying down debt. If you’re struggling to meet your savings goals, you might commit to saving or investing. If you’re already saving enough, you might decide to spend the money on something you’ve long wanted but felt you couldn’t afford. Taking time for consideration can help you decide how best to use your windfall in a way that’s both personally satisfying and financially constructive.

Starting with Awareness

Mental accounting is a single example of how our perception of our finances directly impacts our decision-making. We can’t avoid these unconscious biases, but we can work around them or even embrace them if we’re paying attention. When we work with clients, we see that self-awareness around these patterns can lead to better decision-making and quicker progress toward financial goals. This can include an awareness of one’s habits and tendencies around money, but also a clear articulation of our priorities. Greater clarity allows us to be more intentional with our decisions and build a life that is aligned with our values.


[1] https://www.investopedia.com/terms/b/behavioraleconomics.asp

[2] The framing of financial windfalls and implications for public policy Journal of Socio-Economics

Sam Wood-Bednarz, CFP 

About Sam Wood-Bednarz, CFP®

Sam Wood-Bednarz is a Partner, Lead Advisor, and Director of Financial Planning. He provides clients with a sense of confidence and security in their financial lives.

Read more about Sam

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By |2022-03-11T15:40:10-08:00February 25th, 2022|