Partners (Number 3, 2006)
Partners (Number 3, 2006)
Vol. 16, No. 3, 2006
FEATURES Keeping Pace in a Changing Environment
Split Refunds Link Tax Time to Savings
Many American households are faced with a financial decision at tax time—what to do with their income tax refunds?
While many taxpayers rely on their refunds to help cover basic living expenses, these disbursements also represent the only opportunity for many low- and moderate-income households to consider savings. The average income tax refund is approximately $2,000, and for many families, this is the single largest payment they will receive each year. Research shows that individuals tend to view large, lump-sum payments differently from normal income, so tax time provides a logical opportunity to promote savings.
In 2005, spending by U.S. households exceeded disposable income. For the first time since the Great Depression, the national savings rate was negative. Lack of savings is a concern for households at all income levels, but particularly for the lowest income families who often live from paycheck to paycheck. While these families may need their tax refunds to cover basic expenses, encouraging them to save even a small portion of it could be an important step toward financial stability.
The potential for using tax time to increase household savings is widely recognized. However, many taxpayers have been discouraged from doing so because it has not been convenient. Though many taxpayers now receive their refunds through direct deposit into a bank account, they have only had the option of depositing the refund into one account, and the majority of taxpayers use a checking account. However, surveys indicate that, given a choice, even the lowest-income taxpayers would be interested in directing a portion of their tax refund to a savings account.
IRS creates split refund program
Consumer advocates have been pushing the Internal Revenue Service (IRS) for several years to allow taxpayers to deposit their tax refunds directly into multiple accounts. Studies have shown that individuals are more likely to save if it is easy and automatic. The IRS recently responded with the announcement that taxpayers will be able to split their refunds into as many as three accounts in 2007.
The "split refund" option is a great opportunity to increase savings. Taxpayers will attach a new Form 8888 to their returns indicating how their refund should be allocated among up to three financial accounts. If even a small percentage of all U.S. taxpayers take advantage of this new tool, a significant amount of new savings will be generated each year.
However, the lowest income taxpayers who need the savings the most may face an additional obstacle in taking advantage of this new option: many of them do not have the bank accounts necessary for direct deposit. These taxpayers are also the ones most likely to rely on high cost tax preparers and refund anticipation loans which strip them of the opportunity to take advantage of this new tool.
Financial education a must
Increased access to banking services and financial education are essential to maximize the impact of the split refund option. Taxpayers must be informed about the potential benefits of saving part of their tax refunds and encouraged to open savings accounts prior to tax time.
Volunteer tax assistance programs and nonprofit organizations providing financial education should start encouraging their clients to view their tax refunds in terms of the money they will save as opposed to money they will spend. Financial institutions also have a role to play by providing low-cost saving accounts to eligible taxpayers.
Finally, while tax time presents an opportunity to reinvigorate the savings discussion, a comprehensive national campaign is needed to encourage families at all income levels to increase their savings, thus strengthening their own financial security and helping to reverse the decline in the nation's saving rate.
This article was written by Jessica LeVeen Farr, regional community development manager in the Atlanta Fed's Nashville branch.