Since its inception in 1975, the Earned Income Tax Credit (EITC) has been lauded as one of the most important income-enhancement programs for low-wage workers. The program provides refundable tax credits to people who are working but whose earnings fall below a certain level. For tax year 2008, the eligibility threshold for a married couple filing jointly, with two or more children, was more than $41,000. The amount of the credit was up to $4,824, depending on a worker's income, marital status, and number of qualifying children. In 2007, almost 24 million working families and individuals received EITC refunds, which provided close to $48 billion in additional income.^1/

The EITC provides a direct, measurable, and often substantial increase in the income of low-wage-earning households. However, during the past decade, the impact of the EITC has been affected by the development of the refund anticipation loan, or RAL. RALs are short-term loans backed by the EITC and other refunds that are forthcoming from the Internal Revenue Service (IRS).

RALs enable tax filers to receive refunds quickly, which makes them appealing to people who rely on their refunds to pay for pressing needs like rent, food, and utilities. However, the speed comes at a cost. RALs often entail high interest rates and fees that subtract from the full value of the EITC and other tax refunds. To help tax filers keep more of the EITC money they have coming to them, several organizations have developed alternative refund loan products. This article describes the costs of traditional refund loans and explains how some interrelated partnerships among organizations in the Ninth Federal Reserve District led to the development of a promising alternative to RALs.

The lure of RALs

By the end of the 1990s, financial service companies, including H&R Block, Jackson Hewitt, Liberty Tax Service, and independent tax preparers, were marketing RALs to people who wanted immediate access to their refund money. The companies that provide RALs do a high-volume business with low- and moderate-income clients, many of whom are eligible for the EITC. In 2006, 85 percent of all taxpayers who applied for RALs had adjusted gross incomes of $37,300 or less, and 63 percent of RAL consumers were EITC recipients.^2/

Tax preparation firms that offer RALs screen potential clients, collect the necessary paperwork, complete the tax returns, and file them with the IRS. The preparers also inform the clients about the possibility of getting their refunds quickly—for an additional cost—via a RAL.

The RAL industry includes commercial lenders that are associated with the tax preparation firms. The lenders issue the actual refund loans, because IRS rules prohibit preparers from making loans. The lenders also provide bank accounts for many RAL borrowers. These are usually temporary accounts, established for the sole purpose of collecting tax refunds and dismantled immediately after the refunds are claimed.^3/

The tax preparers and lenders profit through the various fees connected with issuing the RAL, and the lenders also profit from the interest on the refund itself. In 2006, the average EITC refund was $2,600. Average RAL fees on a refund of that size were $140. Combined with an average tax preparation fee of $163, total average fees for a RAL borrower came to $303, or nearly 12 percent of the average refund.^4/ The national total of EITC-related RAL fees and tax preparation fees paid in 2006 is estimated at $1.6 billion. That figure does not include any of the interest payments that RAL borrowers make while waiting for their IRS-issued refunds to arrive. Typically, borrowers pay interest on the combined dollar amount of the RAL and any related fees. In 2006, the effective annual percentage rates for RALs, based on a ten-day loan period, ranged from 83 to 161 percent.^5/

For low-income taxpayers, the appeal of RALs rests on the promise of receiving their loans in 24 to 48 hours—as soon as the IRS approves their tax returns—instead of waiting nine to fifteen days for a direct deposit refund or one to six weeks for a refund check. However, the use of RALs results in these taxpayers paying out a portion of their EITC refunds that could have been put to other uses.

An alternative to RALs

The appearance of RALs has motivated the development of a better, lower-priced way to provide speedy tax refunds to low-wage earners. Coalitions of nonprofit organizations, philanthropic foundations, and financial institutions have been involved in these efforts in different parts of the country over the past several years. In one state in the Ninth District—Minnesota—a collaborative came together in 2005 to design an alternative to traditional RALs. Two community-based organizations—along with four credit unions, a community development bank, and two philanthropic foundations—recently completed their third year of offering the Express Refund Loan and Savings (ERLS) Program, a pilot program that provides a lower-cost alternative to RALs.

The goals of the ERLS are twofold. The first goal is to help taxpayers establish a relationship with a mainstream financial institution, beginning with opening a savings account. The second is to save taxpayers an average of $200 to $300 in tax preparation fees, loan fees, and interest. The ERLS contains several significant components: the loan is offered at a low cost, with fees ranging from $5 to $25, and is linked to free tax assistance; the refund is directly deposited in a savings account; and customers are encouraged to save part of their refunds either in their savings accounts or through other financial products like Individual Development Accounts or Individual Retirement Accounts.

The ERLS was born out of an initial partnership between AccountAbility Minnesota (AAM) and US Federal Credit Union (USFCU). AAM is a 37-year-old community-based organization dedicated to serving low- and moderate-income Minnesotans through high-quality, affordable tax services. USFCU is a community-focused financial cooperative based in the Twin Cities.

In addition to serving thousands of individual clients, AAM operates free tax preparation sites in cooperation with the IRS's Volunteer Income Tax Assistance (VITA) program. (For more on VITA sites and other free tax preparation assistance sites, see the sidebar below.) For several years starting in the mid-2000s, AAM had partnered with the IRS and USFCU to sponsor VITA sites at some of USFCU's branch offices.

Through years of intense involvement with low-income tax filers, AAM staff members were aware of people's need to receive their refunds quickly. They also saw the costs that RALs were imposing on the people they served. Meanwhile, USFCU's involvement in VITA sites, along with its demonstrated practice of providing accessible financial services to underserved members of the community, laid a natural foundation for participating in a partnership to create an alternative to RALs. In 2005, staff members from AAM and USFCU decided to work together to design a refund loan product that would help tax filers keep more of their EITC money.

In a grant proposal submitted to the McKnight Foundation later that year, AAM described the plan it developed in collaboration with USFCU: The two partners would undertake a demonstration project that would initially be located at two of USFCU's VITA sites in Minneapolis, and then expand it to additional sites in Greater Minnesota by the end of a three-year period. The McKnight Foundation decided to fund the project. A second funder was added when the Annie E. Casey Foundation, a national philanthropic organization focused on low-income families and children, came on board in 2006.

Inside the ERLS Program

The pilot ERLS Program was designed to build on the free tax preparation services provided at VITA sites. The program worked like this: When people came to an AAM-sponsored VITA site to have their taxes done, trained volunteers completed the tax returns, informed clients about the pilot refund program, and screened them for eligibility if they expressed interest in participating. Any tax filers whose incomes fell at or below the EITC program's income threshold were eligible to participate in the pilot program.

If clients were interested and eligible, AAM volunteers helped them fill out paperwork to open savings accounts and have their EITC refunds directly deposited into the new accounts. Next, AAM filed their tax returns with the IRS. Once the IRS accepted a return and AAM verified that the client's refund would not be garnished for debt, AAM informed USFCU that the client planned to open a savings account and take out a refund loan, and the client could then visit a branch of the credit union to complete the process and receive the loan. Since no refund loans were issued until the tax returns were approved by the IRS, the pilot program was very low-risk. In addition, the loans would arrive in the taxpayer's bank account within 24 to 48 hours, which was just as quickly as the taxpayer would have received a refund from a traditional RAL-issuing establishment.

Thanks in part to the recruiting efforts of USFCU, four more financial institutions joined on after the pilot program was initially launched: City & County Credit Union in St. Paul, City-County Federal Credit Union in Minneapolis, Northern Communities Credit Union in Duluth, and Community Development Bank of Ogema.

According to Eva Song Margolis, financial services partnership manager at AAM, and Bonnie Esposito, executive director of AAM, "US Federal played an instrumental role. They went out of their way to counsel other financial partners and make calls to interested credit unions in other places to tell them directly about how the program works and how to deal with issues."

The pilot ERLS Program began operating in early 2006. At the end of the 2006 tax season, the program fell short of its goal of 100 loans. In actuality, 23 loans were issued and 73 savings accounts were opened. By the end of the 2007 tax season, however, the program exceeded its expectations. The goal was to issue 400 loans, but 733 were issued instead, at an average amount of $2,375. More than 950 savings accounts were opened; 81 percent of them were still open at the end of 2007, with an average balance of $163. One explanation for the surge in service between the first and second years was the elimination of a first-year requirement that program participants had to have been previous RAL users.

Of the clients served in the pilot program, over 80 percent were people of color and 32 percent had previously been unbanked. The average annual gross income of the clients was $14,121. By taking advantage of the ERLS Program, clients saved an average of $296 compared to the cost of a rapid refund loan at a commercial preparer.^6/

At VITA sites in the Twin Cities area and a few communities in Greater Minnesota, the ERLS Program helped many families and individuals get the most out of their EITC refunds. For a further demonstration of how the ERLS works in practice, it's helpful to look how the program operated in one specific community: the White Earth Indian Reservation in northern Minnesota.

The White Earth experience

In 2004, a Children's Defense Fund report noted that more than half of the taxpayers in one ZIP Code on the White Earth Indian Reservation in northern Minnesota claimed the EITC. More than three-quarters of that group used for-profit tax preparers and RALs, which resulted in an estimated total cost of $22,000 for these working-poor households.^7/

In response to the report findings and their own experiences of working in White Earth communities, the staff of the White Earth Investment Initiative (WEII) decided to change the situation by expanding free tax preparation services for reservation residents. The mission of WEII, a subsidiary of Midwest Minnesota Community Development Corporation in Detroit Lakes, Minn., is to engage in community, economic, and housing development on the White Earth reservation with the aim of alleviating poverty and enhancing the standard of living for individuals residing there.

WEII staff members began their involvement in free tax preparation services in 2004 and 2005 by working collaboratively with an AARP-sponsored tax preparation site in Detroit Lakes. Following the 2005 tax year, WEII staff members decided to establish an independent VITA site focused exclusively on the needs of White Earth residents. WEII staff members had an existing partnership with AAM, having made use of AAM-sponsored training and other resources. After making the decision to establish an independent VITA site on White Earth, WEII staff members turned to AAM for guidance, and AAM provided training, technical assistance, materials, and fundraising support as WEII moved forward in developing the site. In 2006, in a joint effort with White Earth community leaders, WEII established an independent VITA site for White Earth residents. It operates primarily out of the Shooting Star Casino in Mahnomen, the largest city on the reservation, but also provides services in remote reservation locations.

Despite the offer of free tax assistance, usage of the site was low during the 2006 tax season. According to Sarah Ruppel, asset building coordinator for WEII, many potential customers wanted to get their taxes done in a place that provided RALs, even if it meant they had to pay for tax preparation.

Following the 2006 tax season, AAM approached WEII to ask if the organization would be interested in replicating the ERLS Program on the White Earth reservation. Recognizing that the offer of a rapid refund loan would help bring more clients to the VITA site, WEII decided to take AAM up on its offer. Working in partnership with AAM and the nearby Community Development Bank of Ogema (CDB), WEII established an alternative RAL program for the White Earth reservation.

The program, which is modeled closely on the ERLS, is called the White Earth Express Refund Loan and Savings Program. It contributed to an increase in the number of residents seeking free tax preparation services—a jump from 380 in 2006 to 500 in 2007. During the 2007 tax season, the program made 100 loans and clients opened 115 new savings accounts. By the end of the season, only seven of the accounts had been closed. The amount of savings in the remaining accounts ranges from a few dollars to a couple of hundred dollars. WEII made a commitment to encourage White Earth residents to remain "banked"; even if they withdrew all their money from their savings accounts, CDB waived the minimum balance requirement so that the accounts would remain open.

According to calculations based on the 500 tax returns that were completed in 2007, use of the White Earth VITA site resulted in substantial financial benefits for reservation residents. The total amount of EITC refunds claimed was $431,062 and the total refunds returned amounted to $1,015,266. Based on the average amounts that a for-profit tax preparer would have charged per return and per RAL, WEII estimates the alternative RAL contributed to a total savings of $129,500 in service charges and loan fees.

Expanding the program

At the end of 2008, the ERLS program concluded the last year of its three-year pilot phase. AAM staff members are in the process of summarizing their findings and making recommendations about how to expand. Their goal is to take the model to scale without the need to rely on philanthropic foundations for funding.

Bonnie Esposito points out that AAM staff would welcome an expansion of the circle of financial institutions that participate in the alternative RAL program, beyond credit unions and community development banks. But they've found that other Minnesota banks they've talked to feel hamstrung by two factors. The first involves a Minnesota regulation that prohibits banks from opening new checking accounts for people who have written bad checks in the past and had their previous checking accounts involuntarily closed. However, Esposito notes that there are no such regulations prohibiting the opening of savings accounts.

"So, aside from their own internal policies, there is no reason that banks can't open savings accounts for any Minnesotan with a photo ID and Social Security Number or Individual Tax Identification Number," Esposito says.

The second factor contributing to banks' hesitation concerns ChexSystems, a national database of people who have had difficulties managing checking accounts. According to Esposito, one of AAM's partner nonprofit agencies reported that 40 percent of the taxpayers AAM referred to them during the 2008 tax season were on ChexSystems. Another partner reported a figure of 20 percent.

"That's not surprising," Esposito observes. "AAM targets the unbanked for its alternative RAL service, and there's a reason they're unbanked. Usually, it's because they have a blemish on their credit history or they're on ChexSystems. They're turned away from mainstream financial institutions, so they go to fringe banking services that often offer predatory products."

However, Ruppel of WEII notes that the bank affiliated with WEII—CDB—opened savings accounts for all of its customers who used the White Earth ERLS Program. Since CDB was not creating transactional checking accounts for White Earth refund loan clients, the appearance of any of those clients in ChexSystems was less of a concern. AAM staff members say it would be a major breakthrough to find a way to enable a broader range of financial institutions to fully participate in the ERLS Program, perhaps by emulating CDB's example.

The growing national interest in RALs

Although the development of alternative RAL programs is still relatively rare, AAM's and WEII's achievement in creating alternative RALs has inspired and informed work in other states. For example, AAM has been called upon to assist in developing similar programs in Newark, N.J., and Baltimore, Md.

Two other noteworthy alternative RAL programs are also operating in the U.S. Alternatives Federal Credit Union in Ithaca, N.Y., runs one of the oldest and most well-established programs in the country; AAM based much of its pilot program on the Alternatives model. An effort in San Antonio, Tex., is summed up by Skip Loudermilk, vice president of sales and lending for the San Antonio City Employees Federal Credit Union. The credit union is establishing new branches to "take on, head-to-head, payday lenders and check-cashing institutions by offering a low-cost alternative to these products to the underserved and unserved market."^8/ Among these products is an alternative RAL.

Programs like the ERLS have demonstrated their effectiveness in helping low- and moderate-income people keep their full EITC refunds instead of diverting a large share of them to pay fees and interest. Though these initiatives are still in their early stages, their growing success provides an example to other organizations that serve low- and moderate-income clients.

1/ Internal Revenue Service.

2/ Chi Chi Wu, National Consumer Law Center, and Jean Ann Fox, Consumer Federation of America, Coming Down: Fewer Refund Anticipation Loans, Lower Prices from Some Providers, But Quickie Tax Refund Loans Still Burden the Working Poor, The NCLC/CFA 2008 Refund Anticipation Loan Report, March 2008, pp. 11–13.

3/ An Evaluation of the 2007 Tax Season Express Refund Loan and Savings Program, Children's Defense Fund Minnesota, October 2007, p.4.

4/ Wu and Fox, pp.11-13.

5/ Ibid.

6/ A Minnesota Experiment: AccountAbility Minnesota's Express Refund Loan and Savings Program—Fact Sheet, AccountAbility Minnesota, 2008.

7/ Keeping What They've Earned: Working Minnesotans and Tax Credits, Children's Defense Fund Minnesota, February 2006 (revised), p. 5.

8/ Tamarind Phinisee, "City Employees Credit Union is Beefing up Local Branch Presence," San Antonio Business Journal, February 29, 2008.

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