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The pitfalls of Refund Anticipation Loans

Anyone fortunate enough to be getting a tax refund will probably want that money sooner rather than later. But don't let your haste cloud your good judgment. There are a number of less-than-scrupulous outfits out there that are waiting to prey on your desire (or need) for quick cash.

One of my clients is a good example.

When she learned she was getting a refund on her taxes this year -- money she desperately needed to pay the oil bill -- it was all she could do to fight back the tears of joy. Last year, it had been a whole different story.
The client had found me through a flier at a neighborhood senior center that advertised free tax preparation for those who qualified. The center was manned by volunteers from the IRS VITA program, a mixture of retired engineers, a few accountants, some students from the local university and the occasional tax attorney -- which is how she came to be sitting opposite me. Within half an hour, we had e-filed her federal and state returns and requested her property tax rebate from the state. She was entitled to a federal tax refund of a few hundred dollars. I entered her bank account information into the computer and told her she should expect it to hit in about seven to 10 days.

A year ago, things didn't go nearly as smoothly. She had paid just under $200 to file her taxes with a tax preparation franchise and was expecting a refund of about $600, which she desperately needed. Her eyesight wasn't very good, and she didn't understand how to report income from the form RRB-1099 that she received as a result of her husband's old job with the railroad. In addition, she had a handful of old stocks, mostly shares of utility companies, that paid out interest from time to time. She explained to me, almost in a whisper, that up until his death, her husband had taken care of everything. Now that he was gone, she wasn't sure what to do.

She was living from check to check, dependent on her husband's retirement income, and the bills were starting to pile up. She knew she would be getting a tax refund -- she always did -- and a neighbor told her she could get her money back faster by asking for a RAL, a Refund Anticipation Loan. In fact, the neighbor told her, she would get her money the very next day.

At the franchise, the woman who took her money at the front desk told her she was making the right decision. Otherwise, she was told, she could expect to wait up to 12 weeks to get her refund. My client didn't think she could wait that long.

She paid a "processing fee" of $75, an additional $60 "service fee" (equal to 10% of her expected refund amount) and a $50 bank fee. Combined with the tax preparation fees, she paid nearly $385. By the time all of the fees were paid, she was left with just over $200, about one third of her initial refund.

The Financial Pitfalls of Refund Anticipation Loans

Each year, the IRS warns taxpayers to be wary of high-interest and high-fee Refund Anticipation Loans. In many instances, tax preparers who sell these products tell the taxpayer that, without a RAL, they will have to wait several weeks -- even months -- to receive their refund from the IRS. In fact, the average wait for a refund from the IRS using e-file and direct deposit is less than two weeks, with many taxpayers receiving their refunds in as few as 10 days.

According to Jean Ann Fox, director of financial services at the Consumer Federation of America advocacy group, about 8.4 million taxpayers in the U.S. paid more than $800 million in fees alone on RALs in 2008 that could have been avoided. That averages out to about $100 in fees per loan. In addition, interest rates for RALs are, on average, 115%. That's not a typo: more than 100%.

In most cases, you're liable for the bank and loan fees even if your RAL is eventually turned down. (In some states, the third-party lender will perform a credit check and may decide to deny the loan.) Additionally, if your loan is approved but you don't receive a large enough refund to cover the cost of the entire loan (or if your refund is retained by the IRS), you may still be required to pay back the loan.

Linked to Tax Fraud

The IRS is also concerned that tax returns processed subject to a RAL may have a higher rate of error and/or fraud. Since RAL-related fees are often dependent on the amount of the expected refund, there is a "financial incentive to take improper tax return positions in order to inflate refund claims inappropriately," according to the IRS.

In 2007, Jackson Hewitt, the nation's number two tax preparer, was accused of a "pervasive and massive series of tax fraud schemes." The Justice Department filed lawsuits seeking to stop tax preparation services at more than 125 Jackson Hewitt stores in cities such as Chicago, Atlanta and Raleigh, claiming that tax preparers were encouraging taxpayers to fabricate expenses and use phony W-2 forms in order to boost refunds.

Despite attempts by several states, including New Jersey, to cap the amount of interest that can be charged for RALs, there has been little success in restricting the ability of third-party lenders to charge as much as they want for taxpayer loans. This is, after all, a free country, and many argue that the right should exist to borrow money at all costs, no matter the consequences -- or until Congress says differently.

Yet, Congress has only taken steps to protect one segment of our population: the military. Members of the armed forces on active duty are prohibited by federal law from receiving most RALs due to restrictions on interest rates. At least one tax preparation service, H&R Block, had created a special Military Refund Anticipation Loan (MRAL), which kept the total amount of interest and fees below 36% in order to allow them to issue RALs to active duty. However, H&R Block was unable to reach an agreement with its lender at those rates and, as a result, it is not offering the MRAL for the 2009 tax season. HSBC is the lender for most of H&R Block's other lending arrangements, including its traditional RAL.

Realistically, it is highly unlikely that Congress will put an end to RALs any time soon. The products are a booming business for banks and tax preparers. Similarly, regulation of RALs is clearly not a priority for Congress, despite support for the idea by the IRS.

So it's fair to say that taxpayers shouldn't expect the RAL to go away. And as much as I despise the idea of RALs, on some level, I respect the rights of people to make their own decisions about what's good (and not so good) for them. However, to make well-informed decisions, you need information -- and that's where many tax preparation services fail.

The Basic Rules of RALs

Tax preparation services should include details about the differences between various loans and any applicable limitations. H&R Block, the nation's leading commercial tax preparer, does a fairly decent job of summarizing its basic loan options online (though I'd love to see them list their prices). I would encourage you to do your homework on your preferred preparer before you step foot in the office, so there are no surprises. If the information isn't readily available, consider switching to another preparer.

Remember, too, that a RAL is a private arrangement between the taxpayer, the tax preparer, and a third-party lender and is subject to the terms of their contract. Read the fine print before you sign the contract. Don't be rushed into signing up for a service you may not need.

Also, ask yourself how desperately do you need that money? Can you wait an additional day before receiving your money? If so, there are generally two-day options that are significantly cheaper than an "immediate refund." Keep in mind, too, that waits of seven to 14 days (not unusual for many of these loan products) are what you can expect from the IRS when you use e-filing and direct deposit -- and neither of those options cost a penny in fees.

Statistically, RALs tend to be most attractive to lower income taxpayers. But remember that there are other alternatives available which can result in your keeping all of your refund. For more information on free tax assistance, including the VITA program, check out this prior post.

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