February 23, 2024

Unitranche

Supportive Business Potential

How And Why You Should Avoid Tax Refund Loans This Tax Season

How And Why You Should Avoid Tax Refund Loans This Tax Season

Tax season is almost upon us, and it’s not surprising that this can mean something different for everyone. While owing money is never very fun, tax time for people who get refunds may involve planning out big purchases from new furniture to electronics. Some people even use their tax refund to pay for a tropical vacation every year.

Tens of millions of households wind up getting money back when they file their tax return every year. In fact, the Internal Revenue Service (IRS) reported that 96,274,000 households received an average refund of $3,039 in 2022 for the 2021 tax year. These figures are up quite a bit from the 95,632,000 consumers who got an average refund of $2,827 the year before.

This is despite the fact refunds are made up of consumer’s money, and that they indicate someone gave an interest-free loan to the government. Worse, a large number of Americans opt to access their refunds faster with the help of a tax refund loan. While a tax refund loan may not seem like a big deal since your refund amount will ultimately pay it off, there are some serious downsides that come with this type of financial product.

What Is A Tax Refund Loan?

Before we dive into all the downsides of tax refund loans, I want to describe how these loans work. Essentially, tax refund loans — also called “refund anticipation loans” — are short-term loans that use your tax refund amount as collateral. You typically apply for a tax refund loan with your tax preparer when you file your tax return, and this helps you get your money right away.

Almost all of the major tax filing companies offer their own refund anticipation loans each year, and their terms can vary. While some refund anticipation loans are a considerably better deal than others, these loans are never risk-free, and they tend to be loaded with fine print and hidden terms.

Fees And Fine Print

Michael P. Griffin, who teaches finance and accounting at the University of Massachusetts Dartmouth, says that the biggest downsides of refund anticipation loans come in the form of fees and fine print that make them expensive.

In fact, many tax refund loans come with high interest rates and fees that can eat into the amount of the tax refund, said Griffin.

Take the Early Refund Advance Loan from Jackson Hewitt, for example. This tax refund anticipation loan has a finance charge of 6% of the loan amount, and the annual percentage rate is 34.22%.

While Jackson Hewitt does offer a “no fee” refund anticipation loan, not everyone can qualify.

According to the Financial Industry Regulatory Authority (FINRA), some refund anticipation loans come with other fees that may not be totally obvious. These can include loan application fees as high as $100, tax preparation fees of around $40, check processing fees, fees for setting up a temporary account, and more.

When all the hidden charges are combined, FINRA says you can expect to pay approximately $200 in fees on a $2,000 tax refund, or around 10%.

Cycle Of Debt

In addition to having to pay unnecessary fees, Griffin says there is a risk that the tax refund may be delayed or reduced for various reasons. When this happens, the borrower may be left unable to repay the loan.

If you think you’re getting $3,000 back but your tax refund actually winds up being reduced to $2,000, for example, you would be on the hook for paying the difference. However, you may not find this out until after you spend the money and it’s too late to adjust your loan amount.

Griffin also adds that some critics argue tax refund loans can create a cycle of debt for taxpayers who are already struggling financially. For example, consumers might use their tax refund loan to pay off debt accrued throughout the year, but without making any lifestyle changes that stop them from racking up more debt over time.

They might opt to maintain the same level of withholdings from their paycheck to achieve a large refund the next year as a result. Ultimately, they might decide to take out a tax refund loan to get their money faster, even if it means sacrificing part of their refund along the way.

How To Avoid Tax Refund Loans

To avoid the high costs and fine print associated with refund anticipation loans, you should just not get one. At the very least, check around for tax refund loans that don’t have any extra charges to see if you can qualify. I already mentioned how Jackson Hewitt offers a no-fee anticipation loan option, and other tax preparers like TurboTax offer similar refund loans with no fees and no interest charges required.

Paul T. Joseph, who is an attorney and accountant for Joseph & Joseph Tax & Payroll in Williamston, Michigan, adds that another way to avoid tax refund loans involves filing your taxes as early as you possibly can.

“Once you have all of your documents, it is best to file as quickly as possible, and do so through the e-file program at the IRS,” said Joseph, adding that consumers who file early enough can get their tax refund back in as little as 10 days provided they opt to have their refund direct deposited in their bank account.

According to Griffin, other ways to avoid having to take out a refund anticipation loan include saving up money throughout the year to cover any unexpected expenses and exploring alternate sources of funding. For example, borrowing from friends or family, using a credit card, or applying for a personal loan from a bank or credit union can be much less expensive than the worst tax refund loan options.

Over the long-term, you can also consider adjusting your withholding on your paycheck so you get access to more of your hard-earned income throughout the year. This will ultimately lower the amount of your tax refund come March or April each year, but it can improve your cash flow all along.