Last Updated: March 1, 2010
You've probably heard the pitches for "refund anticipation checks" or "quick tax loans." The official name is refund anticipation loans, or RALs. They're marketed primarily to cash-poor taxpayers who use their annual federal and state tax refunds as a piggy bank for discretionary items or thanks to a struggling economy, essentials like food and housing.
In tough times, these high-cost loans are a particularly dangerous temptation. Most of the major tax preparation services in the country offer them, making them easy to apply for and they even offer to place the refund amount in a special prepaid credit card instead of your own bank account.
Do they make sense? The Consumer Federation of America lumps Refund Anticipation Loans (RALs) with their more notorious cousin, payday loans, in the same basket. A February 2009 report indicated that RALs generated an estimated $900 million in fees from 8.67 million taxpayers who used them based on 2007 figures alone. The truth is that while these services promise your refund money immediately or in a few days (less fees and costs), if you're willing to wait an extra couple of weeks, the Internal Revenue Service (IRS) will pay back your refund without fees or interest charges when you file IRS Form 8888 with your return.
The IRS option also makes it easy to divert your refund into an Individual Retirement Account (IRA) contribution or the purchase of U.S. Treasury securities or U.S. Savings Bonds.
In 2007, the Consumer Federation and the National Consumer Law Center reported that RALs cost the average borrower from about $30 to more than $125 in loan fees. Some tax preparers also charge separate fees on top of those amounts for the "application." In their study, both agencies reported that the effective annual interest rate (APR) for a RAL can range from about 40 percent to more than 500 percent, and if application fees are charged and included in the calculation, the effective APRs range from about 57 percent to more than 1,100 percent.
In January, the California attorney general reached a $4.85 million settlement with H&R Block, funneling that money to the state's customers who took out those loans between 2001 and 2008 and prohibiting the tax giant from marketing refund anticipation loans as early tax refunds.
All this aside, the real point is that it's important for individuals to plan their finances and tax strategy so they don't have to be desperate for a tax refund in any amount. If you're working with a tax advisor or a financial planner such as a financial planning professional, they'll tell you that the best way to put cash in your hand is through tax planning, not overpayment of tax so you can get a check later.
It's been said that tax refunds are really interest-free loans to the government, and it's true. The benefit of working with a qualified tax professional or a financial planner is that they might have more incentive to lead you in the direction of sensible tax strategies than a tax preparation firm that offers such loans. Why would any firm offer smart tax advice when it might threaten such a huge revenue stream?
Want to put extra money in your pocket all year round, not just at tax time? Consider the following steps:
- Make 2010 the year you do some real tax planning: Qualified tax professionals such as Certified Public Accountants (CPAs), enrolled agents (federally licensed individuals who have passed a comprehensive IRS exam) or tax attorneys can help you devise a strategy so you and Uncle Sam don't owe each other anything at tax time. You'll do this through smart withholding and finding legal deductions that might create tax savings. Many individuals can get by with the help of an enrolled agent or CPA, and while there are many tax attorneys who do individual returns, they are typically used for business returns or more complex individual tax situations.
- Restructure your spending: Understanding your spending will prevent you from looking desperately for cash at other times. A financial planner can give you some critical advice in building a budget that fits you and your income and spending picture, or you can make this the year when you buy a financial tracking program for your computer and start typing in your daily spending – that activity alone will be an eye-opener. Once you do that, you can figure out how to afford essentials and extras in a way that will prevent a panicky search for money around tax time.
- Make smart choices for that money: Quit thinking about your refund as an excuse for a trip to the mall. Why not use an unexpected tax refund to fund an IRA or some other savings or investment vehicle? If you finish your taxes early enough you might be able to deposit that overage directly in those accounts.