Taxpayers often wonder how to repay their tax debts. But with inflation and rising interest rates, these questions are becoming more common, and the standard answers don’t always apply.
To make a good decision, it is important to understand how the IRS applies interest and penalties to tax bills.
Penalties
Two common penalties for individual taxpayers are default in payment (FTP) and default in reporting (FTF). The FTP penalty is 0.5% of the unpaid taxes for each month the tax remains unpaid. The FTF penalty is much higher – 5% of unpaid taxes for each month late filing – which is why you must file even if you can’t pay what you owe. In either case, the penalty will not exceed 25% of your unpaid taxes.
A Quick Note: The IRS recently announced that they will automatically waive the FTF penalty for individual returns for the 2019 and 2020 tax years filed on or before September 30, 2022.
Importantly, the IRS charges interest on penalties.
Interest
For people who owe money to the IRS, the interest rate is calculated using the federal short-term rate plus 3 percentage points. The IRS sets and publishes interest rates quarterly for the current year and previous years. You can consult the current rates and the rates of previous years on the IRS website.
Payment Considerations
This backdrop is key to understanding your options – math matters. But I also appreciate that convenience, long-term consequences, and the ability to rest easy at night are also important in your decision-making process. Although it’s best to pay now, it’s not always realistic. Here are some general recommendations for dealing with unpaid tax bills when you can’t pay immediately. Your mileage may vary.
just say no
Empty retirement accounts. Draining your retirement accounts to pay off an unpaid debt can be tempting, and the IRS considers funds held in a retirement or profit-sharing plan to be assets available for collection. But I still maintain that draining retirement accounts should be avoided for most taxpayers.
Beyond the obvious – you’re giving up the money you’ve been counting on for your future – you’ll take an immediate hit. Withdrawals from most accounts will be taxable, so you will have to pay tax on the money you use to pay taxes and, depending on your age and circumstances, you may also be subject to an early withdrawal penalty of 10%. Certain penalty exceptions may apply, including funds used to settle an IRS levy under Section 72
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