4 Smart Ways to Cope With a Tax Bill You Can’t Afford

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Discovering that you owe the IRS money is never a good feeling. If you’re staring down a tax bill you can’t afford to pay from 2022, you’re no doubt in good company.

Surprise tax bills can happen for all sorts of reasons. Gig work and side hustles can fatten your liability. Some people are surprised to learn after being laid off that even unemployment benefits are taxable. Or maybe you withdrew money from a retirement account or simply failed to have enough money withheld from your paycheck. Whatever the reason, you have options.

4 Smart Strategies for Dealing With a Tax Bill You Can’t Afford

The most important thing to know if you owe: You do have options. But it’s essential that you take action. Here are four mistakes to avoid — and what to do instead.

Mistake #1: You don’t file a tax return because you can’t pay your bill.

The smart strategy: File a return, even if you can’t afford to pay.

The penalties for not filing a tax return are much tougher than the penalties for not paying on time. Here’s how it works:

  • If you don’t file a tax return: You’ll pay a 5% monthly late fee, up to 25% of the tax bill, plus interest.
  • If you file your tax return on time but don’t pay: Your late fee is just 0.5% per month, also capped at 25% of the bill, plus interest.

Note that filing for a tax extension only gives you more time to file. It doesn’t give you more time to pay taxes if you owe. But if you ask for an extension by Tax Day, which is April 18 in 2023, and file your return by the Oct. 16 extension deadline, you’ll pay only the lower late payment fee instead of the 5% monthly fee for filing a late return.

When you don’t file a tax return, the IRS can file a substitute return on your behalf. If that happens, you’ll still want to file your own return. The substitute return won’t include tax deductions and tax credits that could potentially lower your bill.

Mistake #2: You use a credit card or cash advance to pay your taxes.

The smart strategy: Apply for an IRS payment plan.

This one’s a head-scratcher because even the IRS suggests paying taxes you can’t afford with a credit card or cash advance. Apparently, the IRS doesn’t realize its own generosity as a creditor.

A much better option is to apply for an IRS installment plan. You’ll still accrue penalties and interest. But when you sign up for an installment plan, the monthly 0.5% late fee drops to 0.25%. With interest, that works out to 6% annually.

By comparison, the average credit card APR is above 20% as of February 2023. Cash advance APRs are even higher, plus they often come with additional fees.

Typically, the IRS will automatically approve your agreement if you owe less than $10,000 and you agree to pay off your bill within three years, with no monthly payments required. If you owe more or need more time to pay, the IRS could technically ask for more financial information. But as long as your balance is $50,000 or less, odds are still high that you’ll be automatically approved. The maximum repayment time frame is 72 months, so your monthly payments can be as low as 1/72 of your balance.

You’ll pay a $31 fee if you apply online and have money automatically withdrawn from your bank account each month. The fees are higher if you set up the plan by phone, in person or by mail, or if you choose a different payment method. Setup fees can be waived if the IRS considers you low income, which means your income is below 250% of the federal poverty level for your state.

While you’re in a payment plan, any future tax refunds will be applied to your balance until you’ve paid it off. But the IRS won’t take further action, like garnishing your wages or placing a lien on your property, as long as you’re paying as agreed.

Mistake #3: You hire a tax settlement company.

The smart strategy: Negotiating with the IRS yourself.

If you’re seriously delinquent on taxes, you may need professional help. If you fall in this camp, only an attorney, a CPA or a type of tax adviser called an enrolled agent can represent you before the IRS. But most people who owe taxes won’t need the help of a pro.

Be extremely wary of companies that claim they can stop wage garnishments or settle your debt for a fraction of what you owe. The Federal Trade Commission warns that the vast majority of taxpayers don’t qualify for the programs they’re hawking. Many people who use these companies don’t get tax relief. Instead, they wind up deeper in debt due to high upfront fees and unauthorized charges.

You typically don’t need assistance to set up a payment plan. But even if you can’t afford to start paying your bill or your installment agreement isn’t approved, you do have options for negotiating with the IRS.

One option is to ask for currently not collectible status, which means the IRS will pause collection efforts until your financial situation improves. You’ll still owe taxes, and interest and penalties will continue to accrue. The IRS will require you to show proof of significant hardship and document your income, spending and assets.

Another possibility is an offer in compromise, which allows you to settle your tax debt for less than you owe. You can do this either with a lump-sum payment or with monthly installment payments. The IRS rejects most applications for an offer in compromise. Typically, your tax bill has to be large enough that the IRS agrees it can’t realistically collect what you owe. Use the IRS Offer in Compromise pre-qualifying screener to determine whether this could be an option.

Mistake #4: You take a 401(k) withdrawal.

The smart solution: If you must touch your retirement money, stick with a 401(k) loan or your Roth IRA contributions.

We’d recommend an installment plan hands-down over touching your retirement money. But if that’s not an option — or if you’re determined to get rid of this tax debt ASAP at any cost — an early 401(k) withdrawal should only be the last option.

With an early 401(k) withdrawal, you’ll be racking up more taxes just to pay your taxes. Your distribution will be taxed as ordinary income, plus you’ll pay a 10% penalty.

A 401(k) loan may be a better option since you won’t be penalized. But it’s still risky. If you left your job for any reason, you’d have to repay the loan in full when you file your tax return the next year. Otherwise, it’s treated as an early withdrawal.

If you’re using retirement money to pay taxes, start with your Roth IRA if you have one. If you can limit your withdrawals to your contributions, you won’t pay taxes or a penalty, since that money has already been taxed.

Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].