3 relatively cheap ways to pay off tax debt

Tax debt is scary. The longer you take to pay Uncle Sam, the more penalties and interest the IRS will add to your original bill.

Your best bet is to pay off tax debt as quickly as possible — right away if you’re able. You can do that in multiple ways, and some, such as personal loans or payment plans, are better than others.

Let’s look at how to pay off tax debt before it balloons.

What to know about tax debt

The coronavirus pandemic has prompted the IRS to postpone Tax Day for two years in a row. This year, you have until May 17 to file and pay your 2020 taxes.

But whether you’re facing a tax bill for 2020 or have tax debt from previous years, you’ll eventually have to pay what the IRS says you owe. If you don’t pay all your federal income tax by the filing deadline, interest and penalties will begin to accrue.

Currently, the interest rate is 3%. This applies to the original tax, any accumulated interest, and penalties, and it compounds daily until you pay in full.

The penalty for not paying all or part of your tax obligation is 0.5% of the unpaid amount every month until you pay the full amount, or until penalties add up to 25% of the amount of tax you owe. And, if you’re also behind on filing your tax return, additional penalties can apply.

Paying your tax bill as quickly as possible is the best way to avoid interest and penalties from the IRS.

How to pay off tax debt: 3 options

If you don’t have the money on hand to pay off tax debt right away, credit can be a viable alternative — and likely cheaper than letting interest and penalties add up.

Here are three possibilities to consider:

Personal loan

You can use a personal loan for almost any personal expense, including paying off tax debt. If you have good credit, you may be able to qualify for a good rate on a personal loan.

Pros of using a personal loan to pay tax debt

• You’ll avoid the IRS failure-to-pay penalty.
• You’ll have predictable monthly payments.
• You eliminate the risk of the IRS issuing a lien on your personal property.

Cons of using a personal loan to pay tax debt

• You’re increasing your debt.
• Applying for a personal loan could negatively affect your credit (though repaying the loan on time should help your credit recover).
• If you don’t qualify for a good rate, you could ultimately end up paying more.

Credit card

Credit card interest rates are typically higher than personal loan rates, and IRS penalties and interest. But if you can qualify for a credit card with a 0% APR introductory period, and can pay off the debt before the promotional period ends, a credit card could be an interest-free way to manage tax debt. If you can’t pay it off before the introductory period ends though, you may face steep interest charges.

Pros of using a 0% APR credit card to pay tax debt

• You might avoid paying any further interest on the debt.
• You can spread out your payments over the promotional period.
• You avoid adverse action from the IRS, such as penalties or liens.

Cons of using a 0% APR credit card to pay tax debt

• If you don’t pay off the debt by the end of the introductory period, interest will be retroactive to when you opened the card.
• Opening a new credit card can affect your credit score.
• If you have trouble making payments over time, you could find yourself deeper in debt.

Home equity

Tapping your home’s equity to pay tax debt should be a last resort. Tax debt is technically unsecured debt, meaning your property, such as your home, isn’t at risk — unless the IRS files a lien. Paying off tax debt through a home equity loan, home equity line of credit, or cash-out refinance turns your unsecured tax debt into a debt secured by your home.

That said, if your unpaid tax debt would put you at risk of not being able to make your mortgage payment, or the IRS may place a lien on your home, withdrawing equity to pay off the debt may be a viable solution.

Pros of using home equity to pay tax debt

• Eliminates the risk of the IRS placing a lien on your house and other property.
• May allow you to finance the debt at a lower interest rate than a personal loan.
• Allows you to repay the debt over a much longer time period.

Cons of using home equity to pay tax debt

• You’re increasing how much you owe on your mortgage.
• You’re decreasing your home’s equity.
• You’re putting your home at risk if you’re unable to keep up with a higher monthly mortgage payment.

Options when you can’t pay in full immediately

If using credit to pay your tax debt in full right away isn’t an option for you, the IRS offers multiple ways to pay off your debt over time.

Keep in mind, though, that in most cases, interest and penalties will continue to accrue until the debt is paid in full. And you may have to pay fees to set up the payment alternative with the IRS.

Here are some IRS payment options to consider:

Payment plans

If you owe $50,000 or less (taxes, penalties and interest combined), you can request a long-term payment plan that lets you pay monthly amounts until you pay off the debt. If you owe more than $50,000 but less than $100,000, you can apply for a short-term installment plan.

You can pay through:

• Direct debit from a checking or savings account
• Online or by phone through the Electronic Federal Tax Payment System
• By check, money order, debit card, or credit card

Temporary delay in collection

If financial hardship is making it difficult to pay your tax liability, you can ask the IRS to hold off putting your unpaid taxes into collections. The service may ask you to provide proof that you can’t afford to pay right now before it agrees to hold off on the collection process.

It’s important to realize this is only a temporary reprieve; you’ll be expected to pay the debt — plus interest and penalties — when your financial situation improves.

Penalty abatement

You may be able to ask the IRS to waive penalties for not paying your tax on time if you meet these requirements:

• You didn’t have to file a return, or had no penalties, for three years before the year for which you were penalized;
• You’re current on your most recent return, or requested and got a filing extension;
• You paid, or are making payments, of tax you owe.

While penalty abatement means you won’t be charged interest on the penalty that the IRS waives, you’ll still have to pay interest on the outstanding tax balance.

Offer in compromise

The only real way to settle tax debt for less than you owe is through an offer in compromise (OIC), which you have to request. The IRS will consider your ability to pay, income, living expenses, and assets before deciding whether to grant you an offer in compromise.

Keep in mind that you’ll be expected to pay an application fee, and you won’t be eligible for an OIC if you’re currently in bankruptcy proceedings.

A final word about paying off tax debt

In an ideal world, everyone would be able to pay their tax obligation by the tax deadline every year. Because that’s not always possible, the IRS gives taxpayers installment agreement options that can give you more time to pay. But those alternatives may come with fees, as well as penalties and interest.

Interest and penalties on unpaid federal income tax can be so steep, the IRS actually suggests you may be better off borrowing the money you need to pay your tax bill than face the accruing fees.