As April 17 approaches, many Americans are likely facing the fact that they owe more in taxes than they are able to pay.
“One of the biggest problems we get questions about this time of year are from people owing more in taxes than they thought,” says David Jones, President of the Association of Independent Consumer Credit Counseling Agencies (AICCCA). “Most people are asking which credit cards to use or whether to get money out of their 401(k) to pay their taxes. Unfortunately, those are the last two things you want to consider.”
The consequences of convenience
Using credit cards to pay taxes is tempting because it's quick and convenient. The IRS website features a list of services that lets you pay taxes via credit cards. However, those payments come with service fees ranging from 1.89 to 2.35 percent. Add credit card interest rates ranging from 13.99 percent to 24.99 percent, and most taxpayers will end up paying much more than they owe. A smarter course of action? Making an arrangement with the IRS.
“The IRS payment programs are usually a lot cheaper than using a credit card,” Jones says. “Most people don't know how to deal with the IRS, but actually the IRS is very helpful these days, and all the information needed to get help is easily accessible online.”
In addition to the actual costs of paying taxes with credit cards, the impact on your credit score needs to be considered as well. Credit card balances more than 20 percent to 30 percent of your limit will affect your credit utilization ratio, which in turn could lower your credit score.
Borrowing money from your 401(k) is not the way to go either. Instead, if you owe taxes to Uncle Sam, the AICCC recommends these steps to avoid turning to credit cards or raiding retirement funds:
1. Face the facts. Start planning early. Determine how much you owe in taxes and how much you are able to pay on April 17 to avoid penalties and fees.
2. Cut back. Take a look at your budget to look for ways to cut back on discretionary spending. Take a shopping holiday and cut back on entertainment and meals out. Remind yourself that it's just a temporary cut — and that whatever you save will be that much less you need to borrow.
3. File for an extension. If you aren't able to get your taxes finalized by April 17, you can file for an automatic six-month extension. But keep in mind that you still have to pay at least 90 percent of the taxes owed by April 17 to avoid paying interest or penalties on unpaid taxes.
Filing late or not paying the taxes you owe will result in three types of penalties:
- Penalty for filing late: If you file your tax return late, the IRS can assess you a penalty of 5 percent a month, up to 25 percent, on the unpaid taxes.
- Penalty for paying late: If the taxes owed are not paid by the filing deadline, the failure-to-pay penalty rate is 0.5 percent of the unpaid taxes per month. This increases to 1 percent per month if the IRS sends you a demand for immediate payment or issues an intent to levy assets.
- Interest penalty: In addition to the above penalties, the IRS charges interest on unpaid taxes. The interest is calculated by adding 3 percent to the federal short-term interest rate. Since that rate has been very low for several years, the typical interest charged on unpaid taxes hovers around 4 percent a year.
4. Apply for a short-term payment extension or installment agreement. If you can pay in full within 120 days, you may qualify for a short-term payment extension of up to 120 additional days.
You can apply online and there is no fee to set up the plan. You will still pay interest on the unpaid balance. However, according to the IRS, taxpayers qualifying for a short-term extension of up to 120 days generally pay less in penalties and interest.
If you can't pay the balance within 120 days, another option is to apply for an installment agreement, which will allow you up to five years to pay off the balance (the IRS prefers two years). The fee is $105 to set up the monthly payment schedule.
With a valid installment agreement, the failure-to-pay penalty rate is reduced to 0.25 percent a month, which amounts to 3 percent per year. Add to that the 3 percent to 4 percent interest charged, and you're looking at about 7 percent interest on the outstanding balance. It would be hard to find a credit card offering that kind of rate — especially if your credit isn't stellar — and you don't have to worry about wrecking the credit utilization ratio on your credit cards.
If your inability to pay is due to financial hardship, the IRS may forgive some of your tax debt through an offer in compromise , but generally speaking, these are hard to qualify for and they have numerous drawbacks.
5. Get your tax payments for 2012 in line. When you calculate how much you can pay on your 2011 taxes, get your withholdings for 2012 adjusted, so you don't run into the same problem next year.