Finding the cash to pay a larger-than-expected tax bill can be tricky, but tax pros say there are ways to deal with the surprise without having to pawn the family heirlooms.
1. Take a deep breath
You aren’t about to be arrested. Though crimes such as tax fraud or evasion certainly can come with jail time, the IRS probably won’t send you to prison simply for being short on cash, says Ken Portera, an enrolled agent in East Brunswick, New Jersey.
You’ll get some important mail, though. “They’re going to send you a bill. I mean, it’s as simple as that,” he says. That bill will include interest and probably late-payment penalties, Portera warns. The IRS generally charges an annual interest rate of around 5% or 6% plus a monthly late-payment penalty of 0.5% on unpaid balances.
2. File your tax return on time
“That way, you’re not going to be subject to failure-to-file penalties — because they are significantly higher than the failure-to-pay penalties,” warns Melinda Kibler, a certified financial planner with Palisades Hudson Financial Group in Fort Lauderdale, Florida.
If you’re not done preparing your return, get a filing extension by April 15. But take note: An extension gives you more time to file, not more time to pay.
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3. Pay what you can right away
Because the IRS charges interest and penalties on unpaid balances, sending even a little money with your tax return is better than sending nothing.
“If you can pay down more now, that means less interest and penalties as you scrounge together the rest of the money to cover the bill,” Kibler says.
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4. Look into a payment plan with the IRS
Not many people know these exist, Portera says, but they can show the IRS you’re making an effort to pay what you owe.
Short-term payment agreements. If you can pay your tax bill within 120 days, a full payment agreement might come in handy. It won’t turn back the clock on interest or late-payment penalties, but there’s no fee to set up the plan.
Long-term payment agreements. If you need more than 120 days and owe less than $50,000 in combined taxes, penalties and interest, this could be an option. The setup fees can run over $200, but they can be reduced if you establish automatic payments or are a low-income taxpayer. You can apply online.
Set up a plan that leaves you with some financial breathing room in case life gets in the way and you need cash for emergencies, says Lew Hurwitz, an enrolled agent in Petaluma, California. You can always send extra money if you have it, he notes.
“Because the IRS charges interest and penalties on unpaid balances, sending even a little money with your tax return is better than sending nothing.”
5. Think twice about borrowing or raiding your 401(k)
It can cost more. It might be tempting to pay a tax bill with a credit card so that it’s done (and so you can get frequent-flier miles or other rewards), but the card’s interest rate may be higher than what you’d pay under an IRS payment plan. Plus, paying taxes with a credit card typically incurs processing fees. Hurwitz says, “It really isn’t worth it.”
It’s a slippery slope. Raiding retirement accounts can trigger early withdrawal penalties, Hurwitz adds. Drawing on a home equity line of credit does buy time, but getting a HELOC usually isn’t free. Plus, it can create a temptation to overspend and run up the balance, Portera notes.
6. Make sure it doesn’t happen again
For many people, avoiding a surprise tax bill can be as simple as adjusting their W-4 form, which they give to their employers instructing them on how much income tax to withhold from their paychecks. Increasing the amount withheld can help set aside more tax money for next year — “so you're not in the hole,” Portera says.
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