This tax season, many taxpayers are getting an unwelcome surprise: income tax bills they weren’t anticipating. When that happens, the first instinct is panic. After all, the IRS is not an easygoing creditor. The federal government expects your tax debt to take priority over other debts because they have collection powers other creditors don’t have.
If you find yourself in this unfortunate situation this year, here’s a six-step action plan for dealing with it.
Step 1: File Your Tax Return
When you can’t pay an unexpected federal tax bill, you may be tempted to put off filing your tax return. While you can request a six-month extension using Form 4868, this is only an extension of time to file your return; it’s not an extension of the payment deadline. You’re still required to pay your tax liability by the April 15 due date.
You won’t avoid a late payment penalty or interest charges by holding off on filing until you can scrape the money together. Just file your return as soon as possible (this can be done through H&R Block) and pay as much as you can now. Next, we’ll deal with paying off the remaining balance.
Step 2: Request a Payment Plan
It’s always best to pay the tax you owe when it’s due to avoid interest and penalties. But if you can’t pay your tax debt in full, an IRS payment plan allows you to make tax payments over several months or even several years.
Interest and penalties will continue to accrue on the unpaid balance until it’s fully settled. However, as long as you’re paying your balance as agreed under an installment plan, the IRS won’t take collection action, such as levying your wages or bank accounts or filing a federal tax lien.
There are two basic types of payment plans:
Short-Term Payment Plan
If you can pay your balance in full within 120 days, a short-term payment plan is the way to go. There’s no fee to set up a short-term payment plan. Just call the IRS at 1-800-829-1040 or apply online.
Long-Term Payment Plan
If you need more time, you can request a long-term payment plan, also known as an installment agreement. With an installment agreement, you have up to six years to pay what you owe. But again, you’ll still have to pay interest and penalties on the balance until it’s paid in full, so do whatever you can to pay it off quickly.
You can apply for an installment agreement online, by calling 1-800-829-1040, or by submitting Form 9465. The fees are lower if you request an installment using the online tool and choose to have direct debit payments drafted automatically from a checking account. The IRS has a complete schedule of fees you can check out.
Step 3: Consider an Offer in Compromise Agreement
Are you struggling to make ends meet and wondering how you’ll pay off your unpaid taxes without sliding into severe financial difficulties? If so, an Offer in Compromise (OIC) may be the answer. An OIC allows you to settle your back taxes for less than the full amount you owe.
Before you apply for an OIC, you should know that getting the IRS to agree to accept less than the amount you owe is very rare. They will typically only accept an OIC when the amount you offer to pay is the most they can expect to collect from you within a reasonable period.
As a part of the application process, you have to provide information on your income, expenses, and assets. The IRS will review your application and supporting documents and decide whether to accept your offer. If you have assets that could be sold to pay the debt, your application will likely be declined.
The IRS’s Offer in Compromise Pre-Qualifier tool can help you determine your eligibility and calculate a preliminary offer amount.
Once you’ve used the tool and determined you have a good chance of being approved, you can find step-by-step instructions and all forms you need to apply in the Offer in Compromise Booklet, Form 656-B. You’ll also need to come up with a nonrefundable $205 application fee.
You can offer a lump sum or a series of periodic payments. Either way, you’ll have to include an initial payment, in addition to the application fee, with your submission. The size of your initial payment depends on whether you offer a lump sum or periodic payments.
With a lump-sum offer, your initial payment is 20% of the total offer amount. For periodic payments, you must include your first installment and continue making monthly payments while the IRS considers your offer.
Step 4: Look for Additional Income Streams
Paying off your tax debt is a priority. If you don’t have the cash to pay the balance off quickly, you might want to consider looking for other ways to earn some extra cash. These include:
- Taking on an additional part-time job
- Volunteering for overtime at work
- Working a side hustle in the gig economy (such as driving for Uber or Lyft; sharing your car through Turo; delivering packages for Amazon Flex; caring for children, adults, or pets through Care.com; delivering food or groceries for Doordash, Postmates, or Instacart; or pet sitting and dog walking through Rover)
- Renting out a room in your house on Airbnb or get a roommate through Roommates.com
- Selling stuff on eBay, Craigslist, Facebook Marketplace, or in a garage sale
Just remember, if you make money on a side hustle or by renting out a room, that income is taxable. Be sure to set a portion of your earnings aside to cover taxes and consider making estimated payments so you don’t wind up in the same situation next year.
Step 5: Reduce Your Expenses
If you owe a sizable debt to the IRS and don’t have the money to pay it, your problem may not be earning too little money, but spending too much of what you make. In that case, you need to look for ways to cut your expenses.
Here are a few ideas for decreasing the amount you spend each month:
- Reduce Your Energy Bills. Unplug electrical devices when they’re not in use, use timers and power strips, and lower the temperature on your water heater. Check with your local power company to find out whether they offer free energy audits or lower rates during certain hours or days of the week, and run your major appliances during these reduced-rate hours.
- Cancel Unused Memberships and Subscriptions. How often do you really go to the gym, use all of the products in that subscription box, or read the stack of magazines that get delivered to your house each month? The subscription-based business model is everywhere, and while $5 per month here and $10 per month there doesn’t seem like a lot, it can add up to you spending hundreds of dollars on products and services you hardly ever use. Review your bank or credit card statements for forgotten subscriptions and cancel any you no longer need. You can also use Truebill to help you find unused subscriptions and also to negotiate bills like your cell phone or cable.
- Cut the Cable. According to a recent survey from DecisionData.org, the average household cable package is now $217.42 per month, which is over $2,600 per year. Look for a cheaper way to get access to your favorite shows, or at least downgrade from premium to basic cable.
- Make Meals at Home. Dining out and takeout can save time, but the expense can be tremendous. The average consumer spends $3,526 per year on food away from home, according to the Bureau of Labor Statistics. To save money, look at other options to make eating at home more convenient, such as preparing lots of meals at once and freezing them for easy reheating later.
- Shop Around for Insurance. According to a study from J.D. Power, only about one-third of consumers shop for new auto insurance each year, usually because they believe the potential savings aren’t worth the effort. But those who do shop around saved an average of $356 on their annual premiums. If you haven’t compared homeowners or auto insurance policies lately, see if you can save a substantial amount by switching to another provider. PolicyGenius allows you to compare rates from 10 or more insurers so you know you’re getting the best rates.
These are just a few ideas for saving money that can be put toward paying off your tax debt. Get creative and look for other ways to save.
Step 6: Put It on a Credit Card
As mentioned above, the IRS has collection powers not available to other creditors. When you default on an installment agreement, the IRS can place a lien on your property, levy your bank account, or garnish your paycheck to collect the debt. Faced with that reality, you might consider using a credit card to pay off your tax debt. However, this should only be a last resort for two reasons.
First, paying your taxes with a credit card comes with pretty hefty fees. The IRS accepts credit card payments through third-party payment processors who charge a fee. The fees vary but currently range from 1.96% to 1.99% of your payment amount, with a minimum fee ranging from $2.50 to $2.69.
Second, credit cards typically charge higher interest rates than the IRS does. Currently, the average credit card interest rate is around 16%. By contrast, the IRS interest rate for the first quarter of 2021 is 5%.
This is only a good option if you can pay your balance with a credit card, transfer the balance to a 0% APR credit card, and pay it off within the promotional rate period. Otherwise, paying your tax bill with a credit card can cost you more in the long run.
Above all, it’s vital to get in touch with the IRS as soon as you realize you’re not able to fully pay off your tax debt. Calling the IRS to tell them you can’t pay may be the last thing you want to do, but their representatives are trained to deal with struggling taxpayers and can offer advice on the best repayment options.
At the very least, making contact tells them you’re not purposefully dodging your responsibilities and are willing to work with them.