Does this sound familiar? Either by accident or design, you over–withheld your federal income taxes for 2007. More money was deducted from your paycheck than you actually owe. So, you're due for a refund. Good for you. You can always use the money.
To speed things up, your tax preparer or a retailer eager for your business offers you a tax–refund loan, more formally known as a Refund Anticipation Loan. Should you take the loan or wait for your money to arrive? You decide.
Every year millions of Americans say yes to Refund Anticipation Loans (RALs), for an average amount of just over $2,000.1 They pay a few fees, commit to an interest rate and generally get their money right away, or within a few days. The loan is repaid when the refund arrives. The average total cost of the loan is about $100, mostly in the form of up–front fees.
The problem with RALs, says Chi Chi Wu, staff attorney for the non-profit advocacy group, National Consumer Law Center (www.nclc.org), is that "these are very expensive, very short-term loans.
"The IRS can generally turn around a refund in about eight to 14 days," Wu told New York Life. "Between fees, the rate charged and the short-term nature of the loan, the annual interest rate can be anywhere from 40 percent to over 700 percent."2
The biggest problem is the fees. If a preparer offers a loan of $2,000 for $115, that may not sound like much, but the loan may run for only a week or so. That can be a high price to pay for such a short–term loan.
Additionally, added Wu, there is some risk involved. "If the refund is held up for one reason or another, the taxpayer is on the hook. Remember, these are loans, and the taxpayer is liable for repayment."
These loans may have made more sense when refunds were mailed and could take months to process, but electronic filing has changed all that. Nonetheless, more than 12 million taxpayers paid over $900 million in fees in 2004 just to get their refunds a little faster.3
Here are some alternatives to RALs:
- Adjust your tax withholding. Your refund is not a windfall. It is a return of your own money — cold, hard cash that you have actually loaned to the U.S. government, and you did so at no charge.
Do the math. Let's say that you receive a refund from the U.S. government of approximately $2,000 each year. You probably also receive several hundred dollars from your state. If the total averages $2,500, that comes out to more than $200 a month that you overpaid. That is also $200 that you could allocate to immediate lifestyle enhancement or set aside to build wealth for the future.
- Open a savings account and deposit that extra money each month. Some people say that over–withholding is the only way they can manage to save money for major purchases. So, they do it deliberately year after year. If that is the case, why not "trick" yourself by opening a separate savings account and, if your employer is willing, have that additional money automatically deposited each month? That way, the money is not only there when you want it, but it will also be earning interest for you.
- File electronically. Between that and having your refund deposited directly into your savings or checking account, any money you are due will be in your hands within a few days.
- Be patient. If you would just as soon get a refund every year, file electronically and wait the one to two weeks for your refund to arrive. Have it direct–deposited into your savings or checking account. If you do not have an account (one of the big reasons some people sign up for tax-refund loans), it's time to open one.
Besides, you've done without this money all year. This little bit of patience — willingness to wait one to two weeks —— will save you the cost of that refund loan. Sure, it may not seem like much, but a hundred dollars here, another hundred dollars there…it really begins to add up. Besides, wouldn't you rather spend the money on something more fun or worthwhile?
1 "Tax Refund Loans Show Price of Impatience," The Washington Post, January 23, 2005 (www.washingtonpost.com)
2 12/21/05 author interview.
3 "Income Tax Refund Loans: Taxpayer Rip–off," Deborah Fowles, about.com, a New York Times Company, 2005 (www.financialplan.about.com)
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