The interest on my tax debt is accumulating. Should I pay it back with a loan?
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Dear Credible Money Coach,
I owe the IRS $16,000, interest added daily. Should I take out a loan with interest? — Granny
Hello Mom and thank you for your question. Many Americans feel stressed when tax season approaches. But if you have tax debt, that anxiety can last all year.
Your question highlights the biggest problem with tax debt – interest. When you owe taxes, you may also face penalties, but interest is what keeps your debt growing. And interest will continue to accrue until you repay the debt. Tax debt can be so heavy that the IRS actually recommends taxpayers either liquidate assets to pay their debt or consider getting a loan, as both options may be cheaper in the long run than paying penalties and interest from the IRS.
Before taking out a personal loan for any reason, it is a good idea to compare the rates of several lenders. Credible, it’s easy to view your prequalified personal loan rates.
How Tax Debt Works
From source deductions to estimated tax payments, the IRS expects you to pay at least 90% of the tax you owe in the months leading up to the filing deadline. and payment of taxes, and any remaining balance before the deadline itself.
If you don’t reach that 90%, you could face an underpayment penalty on top of your remaining balance, although there are some exceptions. And, if you make the mistake of not filing a return on time, in addition to not paying your tax liability in full, you may also face a failure to file penalty.
How tax debt can increase
Any tax balance that you do not pay in full on tax day is subject to 3% interest which, as you noted in your question, is compounded daily. Interest applies to the total outstanding balance, including the amount of tax owing, penalties and unpaid interest.
Although 3% may not seem like much, daily compounding can cause your debt to balloon. For example, a tax bill (capital, penalties and interest) of $5,000 can reach $5,152 at the end of the first 12 months if it is not paid.
Options for Repaying Tax Debt
To repay a tax debt, you have several options:
If you have savings to cover that $16,000 balance and tapping into those funds won’t leave you financially strapped, paying off your balance in full immediately is the way to go. The disadvantage of this option is that you will take a significant part of your savings.
IRS Payment Plan
IRS payment plans are an option if you want to break your tax debt down into manageable payments. The IRS allows taxpayers to make short-term and long-term payment plans, and requesting one is quite easy. You can call 800-829-1040 or request a payment plan online.
But IRS payment plans have drawbacks, including interest and fees for setting up or changing your plan. If you opt for a long-term plan, paying off your debt in full could take a long time and interest will continue to accrue until you pay off your balance.
While using the credit for pay your tax bill is literally to swap one type of debt for another, in some situations this can make sense.
If you have a credit card with a large available balance, using it to pay your tax bill might be the quickest option. But that’s rarely the best, because credit card interest rates can be high. At the end of 2021, the average rate on credit cards with assessed interest was 17.13%, according to Federal Reserve data.
Depending on your credit score, your rate could be much higher than average. Additionally, since credit cards are revolving credits, your interest rate and costs may increase while you are pay on debtwith no definite end date in sight.
On the other hand, personal loan interest rates tend to be lower than credit card rates, so if you need to use credit to pay your tax debt, a personal loan may be a cheaper option. At the end of 2021, the average 24-month personal loan rate was 9.39%, according to the Federal Reserve. Since personal loans are installment loans, you will have a specific repayment date and know before you sign on the dotted line exactly how much interest you will pay over the life of the loan.
But personal loans can have drawbacks. Some lenders charge origination or application fees for processing the loan, as well as prepayment penalties if you repay the loan early, so it’s important to fully understand the terms of any loan you’re considering.
Is the personal loan the best option to repay a tax debt?
Grandma, if your credit is good to excellent and you meet the income requirements, you may be eligible for a $16,000 personal loan at a favorable interest rate and terms. A personal loan could allow you to pay off your tax debt and avoid the snowballing interest charges that can come with unpaid tax debt, credit cards, or an IRS installment plan.
Finally, don’t underestimate the mental health benefits you could get from paying off your tax debt. Some forms of debt can be more stressful than others, and tax debt — with its potential to lead to wage garnishment, real estate liens, and seized assets — is definitely a stressful type of debt. You can have peace of mind knowing that you owe a personal lender, rather than Uncle Sam, and that your interest charges won’t keep piling up as you pay down the debt.
You can check your prequalified personal loan rates in minutes, without affecting your credit, when you use Credible.
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About the Author: Dan Roccato is a clinical professor of finance at the University of San Diego School of Business, personal finance expert Credible Money Coach, published author and entrepreneur. He has held senior positions at Merrill Lynch and Morgan Stanley. He is a recognized expert in personal finance, global securities services and corporate stock options. You can find it on LinkedIn.