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3 Reasons Not to Use a Credit Card to Pay Tax Bills

March 2, 2015
Credit Cards, Income Taxes
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You get your taxes back from your accountant, and you feel like you’ve been punched in the gut. There’s no way you can afford that, you think. And while you’re beating yourself up over last year’s mistakes, you consider putting the entire payment on a credit card to delay your payments and earn enough airline points to help you forget the pain.

It sounds like a great idea at first. But when you factor in how much it costs to pay taxes with your credit card, there’s a good chance you’ll change your mind about the whole thing. Paying your taxes with your credit card comes with three big pitfalls:

1. High processing fees

Every time you swipe your credit card, there’s a transaction fee, but you may not know about it, because merchants generally pay it for you. The U.S. tax code prohibits the government from covering fees charged by credit card processors, so your tax bill will include this service charge when you use your credit card on one of the payment processor websites listed by the IRS.

The fees for credit card processing range from 1.87% to 2.35% of the total. Even if you have the credit card with the most generous cash-back rewards on the market, you still may end up losing some money.

2. High credit utilization

Suppose you had a $4,000 tax bill and a $5,000 limit on your credit card. Assuming that was your only credit card, your credit utilization ratio — or the percentage of your available credit you’d be using — would be 80% if you paid your taxes with it. That could ding your credit, because this data point heavily influences the 30% of your FICO score determined by amounts owed. You also could risk maxing out your credit card, leading to even more financial stress.

3. High interest rates

Unless you have a credit card with a promotional 0% APR offer, your plastic likely carries a double-digit interest rate. If you can’t pay your tax bill in full by the end of the month, you could end up shelling out big bucks on finance charges.

Let’s go back to that $4,000 tax bill. If you chose to put it on a credit card, you may first have to pay a 2.35% processing fee, bringing the total up to $4,094. Then, if you credit card charged 20% purchase APR and you made monthly payments of $150 on it, it would take three years to pay off. When all is said and done, you may end up shelling out almost $5,400 just to pay off that original $4,000 tax bill. That’s probably a lot more than you bargained for.

What to do

Paying in full with a direct debit from your bank account is the least expensive way to pay a large tax bill. But when that’s out of the question — for instance, if you simply don’t have the money in your account or it would eat up your emergency savings — there’s always the installment agreement. By setting up this agreement with the Internal Revenue Service, you could pay around 10% less in annual interest than what you’d pay your credit card issuer.

Your installment agreement will generally be approved if you owe less than $10,000. Just like paying off a balance on a credit card, it’s best to pay off your installment agreement as quickly as possible. This way,  you won’t end up paying too much in interest and penalties. Here’s the breakdown of costs:

• Processing fee: You can choose to pay a flat fee of $52 to set up the account as a direct debit to your bank account or $120 to set it up as a payroll deduction agreement or a standard installment agreement. Those with lower incomes may qualify for a lower fee.

• Interest rate: The interest rate you’d owe, updated every three months, is the federal short-term rate plus 3%. Right now, that would add up to 3.46% per year. Like credit card interest, it compounds daily.

• Penalties: Penalties cost an additional 0.25% per month if you have an installment agreement. If you’re just paying late and don’t have an agreement, on the other hand, you’ll have to cough up 0.5% per month, on top of additional fees.

All in all, with an installment plan, you’ll likely end up paying an APR of 6.5% — which is less interest than most credit cards charge — plus the one-time processing fee.

Nerd note: Not everyone will qualify for an installment agreement. If you’re self-employed and haven’t paid quarterly estimated taxes, for instance, the IRS may not let you set up a payment plan. The same goes if you still owe back taxes to the IRS. In these cases, you may owe additional penalties. But for most people, an installment agreement is a good way to cushion the financial blow of a large tax payment without paying all the fees that credit cards charge.

A final word of advice

Whether you decide to bite the bullet and write a large check or set up an installment agreement, don’t forget to fill out a new W-4 with your employer to adjust your withholding for next year. No one likes a large tax bill, but by meeting with your tax accountant early and planning ahead, you won’t be in for the same surprise next year.

Claire Davidson is a staff writer covering personal finance for NerdWallet. Follow her on Twitter @ideclaire7 and on Google+.

Image via iStock.