Tax Dilemma: Seven Options If You Can't Pay Your Taxes

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Whether it's a personal loan, a home equity line of credit, or a loan from your retirement account, there are times when it makes sense to borrow to pay off the IRS. Here are some questions you will want to ask yourself before you go this route:

Questions to ask yourself before using a loan to pay your tax debt:

- Will using a personal loan help you avoid a tax lien? If so, this may be a good option since tax liens can hurt your credit scores significantly.

- What is the interest rate? How does that compare with an installment agreement through the IRS? (See option #4: Request a Payment Plan from the IRS.)

- Can I really afford the payments? Before you tap home equity or borrow against a retirement account, for example, make sure you can afford the payments. If not, you may be better off considering options like an Offer in Compromise. (See option #6: Offer in Compromise.)

Estill warns that using a home equity loan to pay the IRS is particularly risky. "If you use a HELOC or other loan tied to your house and you default, you may lose your house so taxpayers should be very careful about proceeding in this manner," he says. "It is very unlikely, though, that the IRS would foreclose on its tax lien and try to sell the house at a foreclosure/tax sale."

[Related: IRS Eases Up on Tax Liens: Good News for Credit Scores]

Option #4: Request a Payment Plan from the IRS

If you can't pay your tax bill right away, but the debt would be manageable if you had more time to pay, you can request an installment agreement that allows you to make monthly payments until your tax bill is resolved. You can only request this option if you are current on filing all of your tax returns.

If you owe $25,000 or less in combined tax, penalties, and interest, you can use the IRS Online Payment Agreement (OPA) to request your installment agreement, or you can call number listed on the bill or notice you received. If you need to mail in a request, you can use the Request for Installment Agreement, Form 9465.

You'll pay a fee to set up an installment agreement. For the 2010 tax year, the cost is $52 if you agree to have the monthly payments taken from your bank or credit union account, or $105 if you want to pay by check or have payments withheld from your paycheck.

You'll also pay interest compounded daily—plus a late payment penalty. This penalty, usually 0.5% of the balance due per month, drops to 0.25% when the IRS approves the agreement for an individual taxpayer who filed the return on time and did not receive a levy notice. The penalty will be charged until it reaches 25% of the original balance due.

[Resource: Prioritizing Financial Literacy in 2011]

What interest rate will I pay?

For individual taxpayers the underpayment rate is the federal short-term rate plus 3 percentage points. For example, for the first quarter of 2011, the rate is 4%. This rate changes quarterly, and may increase.

Installment agreement requests are automatically approved, as long as:

- You have filed your tax returns on time for the last five years, - You've paid the taxes you've owed during that time without using an installment agreement, - The IRS determines you can't pay the full amount you owe right away, - You agree to pay your tax bill in full within three years.

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