NerdWallet: How To Avoid Hidden Tax Fees If You Filed An Extension

If you applied for an extension to file your income your taxes, you have until October 15th. But that deadline is fast approaching.

So now is the time to think about the best way to file your taxes.

For most households, that means looking forward to a tax refund. For those who choose to file with a professional tax service, the idea of a Refund Anticipation Check (RAC) may seem like an appealing option: pay nothing now and have the tax preparation fee automatically deducted from your tax refund.  

Buyer beware – an RAC may save you money now, but you’ll pay more later.

Too good to be true?

Refund Anticipation Checks (RACs) are the latest incarnation of a financial product that started back in the 1980s. The idea is simple: a professional tax preparation service helps you prepare your income tax return and submit in to the IRS.  Instead of requiring payment upfront, the preparer agrees to defer the cost of their services.  When your refund arrives, the preparer takes out their preparation fee, plus an additional charge.  You then receive your refund, often on a prepaid card issued through the preparer or an affiliate.

Sound like a great way to delay paying for tax preparation?  Think again.

The best things in life are free
Part of the allure of an RAC is that it delays the cost of filing your taxes, but what if you didn’t have to pay anything at all?  In fact, the IRS provides resources that allow many Americans to file their tax returns for free.  According to the IRS, about 70 percent of tax filers have an Adjusted Gross Income (AGI) of less than $57,000, the critical cutoff to qualify for free filing.  In addition, many free filing programs allow you to file your state taxes as well, making the process even simpler.

The cost of paying late
Even if you don’t qualify or choose not to file for free, a Refund Anticipation Check (RAC) is likely a poor option.  The associated finance charges for an RAC can add up to the equivalent of paying over 300 percent in interest. To understand exactly how much an RAC can cost, let’s look an example.   

John decided to file his taxes through a professional tax preparation service this year. While the costs of an RAC vary, the largest tax preparer in the US charges a finance charge of $24.95 for an RAC issued on a pre-paid card (this is in addition to the cost of preparation).1  If John wants the refund direct deposited or issued as a check, there’s an additional $10 or $20 fee, respectively.  Assuming John takes the check option, he will pay $54.95 in fees to defer paying the cost of his tax preparation.  

The IRS indicates that nine out of 10 refunds are issued within 21 days of receipt, so let’s assume it takes John that long to receive his refund. In addition, the average cost of professional tax preparation is $246 according to the IRS. That means John is paying a $54.95 fee to defer his $246 preparation cost for 21 days, the equivalent of a whopping 388 percent interest rate.

Even if he decides to take his refund on a pre-paid card to save an extra $20, John is still stuck paying $2.50 for every ATM withdrawal and an additional $2.50 per month if the card remains unused for 3 months.

Given the hefty fees involved, John would be much better off paying the tax preparation fee upfront.

Don’t get stuck with RAC fees this tax season:
1. Free is (almost always) best! Take advantage of free programs by checking to see if you qualify for free tax filing through the IRS’s free file program.  
2. Plan ahead for the cost of filing taxes.  Saving just over $5 a day between now and October 15 will more than cover the cost of an average professional tax return.  With a little budgeting, the cost of filing taxes can be made more manageable upfront, saving you the hefty fees associated with an RAC.
3. File early for the fastest refund. While the deferred deadline for tax filing is October 15, families can file their taxes any time between now and then.  Earlier filers tend to receive their refund faster, reducing the financial strain of waiting for your refund.

Alex McAdams is a strategy associate at NerdWallet, a national personal finance website whose Ask an Adviser feature gives consumers a new way to connect with financial advisers.