Before the advent of electronic filing of tax returns in the 1980s, taxpayers had to mail in paper returns to the IRS and then wait weeks or months for their refund checks to arrive. But modern technology brought about the growth of a new industry that made billions of dollars by making short-term loans to taxpayers in return for their refunds as payment. From the beginning, this practice – known as refund anticipation loans (RAL) – attracted criticism from many consumer groups, and regulators eventually followed suit. These usurious loans are now a thing of the past, and for good reason.
The History of Refund Anticipation Loans
RALs became popular products with preparers after electronic filing was made available. RALs provided preparation firms with a way to get customers quick cash and then have their refunds deposited directly into the preparers’ bank accounts. Of course, the amount fronted to customers was substantially less than the amount of the refund, and preparers made a tidy profit from this arrangement by charging additional fees that went to them and not the bank. Tax professionals quickly learned that the working poor provided an ideal market for these loans, as they were quite often strapped for cash after the holidays and needed money as soon as possible. Furthermore, their general lack of education also prevented the majority of them from understanding that they were usually getting ripped off. This service became even more enticing when the earned income credit (EIC) was expanded in the 1990s to give larger refunds to low-income filers. Providers typically enhanced the appeal of using RALs by simply taking the fees for tax preparation directly out of the reduced refund, thus making it much easier for customers to file without having to pay anything out of pocket.
Those who did not use this service were usually required to pay up front in order to file. Over 12 million RALs were issued in 2004 at a cost of $1.24 billion to filers, and 2009 data from the IRS revealed that almost 90% of customers who used this service were low-income filers and about two-thirds of them received the EIC.
The Problems with RALs
From the beginning, RALs were attacked by consumer advocate groups such as the National Consumer Law Center (NCLC), state attorney generals and even the Federal Trade Commission, which lost a suit against them in 1976. These opponents criticized the exorbitant interest rates and other fees that these loans charged. Most RALs charged triple-digit interest rates on the funds that were advanced for the length of time between the day the loan was issued (which was usually the day after the return was filed) and the day that the actual refund was issued. This would often amount to several hundred dollars for those who got large refunds, dollars that were sorely needed by low-income filers to pay bills and stay afloat. Republic Bank and Trust was the last lender to fund RALs; it charged a fee of $61.22 for a maximum advance of $1,500 in 2012 – which came out to 149% on an annualized basis. There was an additional $30 fee to cut a check for any refund amount in excess of the RAL limit. The NCLC estimated that about $465 million worth of EICs that were owed to taxpayers in 2008 were instead used to pay for RALs, with another $42 million of add-on fees coming on top of that.
This reduction affected 24 out of every 25 filers who received EIC.
Perhaps the biggest drawback to these loans came for those whose refunds were intercepted by the IRS to pay off outstanding obligations. These customers would then become liable for the entire loan amount with no refund coming to pay for it.
When RALs were first introduced, filers often had to wait weeks or even months to get their refunds. But when the IRS began downloading all of its information onto computers at the dawn of the millennium, it became able to process tax returns much more quickly. Most taxpayers who file electronically and opt to have their refunds dispersed by direct deposit or loaded onto prepaid debit or bank cards can now expect to get their refunds in about five to 10 days, and this time frame will most likely continue to shrink in the future. This increased efficiency made the high costs of RALs even harder to justify. In 2010, Doug Shulman, who was then the commissioner of the IRS stated, “I think it’s unfortunate that there’s a lot of hardworking Americans that are in a financial situation where they have to pay a substantial fee to access their refunds a week or two before they can get it from the IRS.”
Many preparers also still offer options that allow filers to have their preparation fees taken out of their returns instead of having to pay up front. Although they still usually charge an additional fee for this service, the cost is only a fraction of what they charged for RALs. Some firms, such as Jackson Hewitt, have turned to offering direct loans or lines of credit in lieu of RALs as a way to provide customers with a way to get at least a portion of their refunds earlier, although these loans are not automatically paid off when customers receive their refunds. But private equity firms may also become interested in financing RALs at some point in the future, as they are free from the regulations that apply to the banking industry, and there is clearly a substantial profit to be made with them.
The beginning of the end came for RALs in 2010 when the IRS announced that it would no longer issue debt indicators on taxpayers that showed when a filer owed back taxes or other debts, such as delinquent student loans or child support. This was a major blow to the RAL industry, as the banks that provided the loans for customers used them to determine whether or not a customer was eligible for an RAL. Most banks ceased to offer RALs as a result of this change, and they disappeared altogether after 2012.
The Bottom Line
The demise of the refund anticipation loan marks a major turning point in the tax preparation industry. Many preparers who previously relied on the income that these loans generated for them have been forced out of business, while others have had to cope with reduced revenues. But customers who opted for this service will now see larger refund checks, albeit a few days later. For more information on the current alternatives to RALs, consult your tax preparer or financial advisor.