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Dear Credible Money Coach,
I owe the IRS $16,000, interest accruing daily. Should I take out a loan with interest? – Mummy
Hello Mamie, and thanks for your question. Many Americans feel stressed when tax season begins. But when you have tax debts, that anxiety can stretch throughout the year.
Your question highlights the biggest problem with tax debt – interest. If you owe taxes, you can also face penalties, but the interest keeps your debt growing. And the interest will accrue up to you pay off the debt. Tax debt can be so onerous that the IRS actually recommends taxpayers either liquidate assets to pay off their debts or consider taking out a loan, as both options can be cheaper in the long run than paying IRS penalties and Interest charges.
Before you take out a personal loan for any reason, it’s a good idea to compare interest rates from multiple lenders. Believable makes it easy View your prequalified personal loan rates.
This is how tax liability works
Whether it’s payslips or estimated tax payments, the IRS expects you to pay at least 90% of the taxes owed in the months leading up to the tax return and payment deadline and the remaining balance by the deadline yourself.
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, not only can you fail to pay your full tax liability, but you can also face a non-filing penalty.
How tax debt can grow
Any tax balance that you fail to pay in full by the tax day will be subject to 3% interest which, as you noted in your question, is compounded daily. Interest applies to the entire unpaid balance, including the amount of tax owed, any penalties and unpaid interest.
While 3% may not seem like a lot, the daily compounding can cause your debt to skyrocket. For example, a $5,000 tax bill (principal, penalties and interest) can grow to $5,152 by the end of the first 12 months if not paid.
Ways to pay off tax debts
When it comes to paying off tax debts, you have several options:
If you have savings to cover that $16,000 balance and diving into those funds won’t leave you financially strapped, paying off your balance in full immediately is the way to go. The downside of this option is that it takes a significant bite out of your savings.
IRS Payment Plan
IRS payment plans are an option when you want to spread your tax debt into manageable payments. The IRS allows taxpayers to create short-term and long-term payment plans, and applying for one is fairly easy. You can call 800-829-1040 or request a payment plan online.
However, there are downsides to IRS payment plans, including interest and fees for setting up or changing your plan. If you choose a long-term plan, it can take a long time to pay off all of your debt, and interest will continue to accrue until you pay off your balance.
While using credit at pay your tax bill literally swapping one type of debt for another can make sense in some situations.
If you have a credit card with a large available balance, using it to pay your tax bill may be the fastest option. But it’s rarely for the best, as credit card interest rates can be high. At the end of 2021, the average rate on interest-bearing credit cards was 17.13%, according to Federal Reserve data.
Depending on your credit score, your rate can be much higher than average. Because credit cards are revolving credit, your interest rate and expenses may increase during this time pay the debtwith no definitive end date in sight.
In contrast, Interest on personal loans are usually lower than credit card rates. So if you need a loan to pay off your tax debt, a personal loan can be a cheaper option. At the end of 2021, the average interest rate on a 24-month personal loan was 9.39%, according to the Federal Reserve. Since personal loans are installment loans, you have a specific payout date and you know exactly how much interest you will pay over the life of the loan before you sign the dotted line.
But personal loans can come with disadvantages. Some lenders charge processing or application fees for processing the loan, as well as prepayment penalties if you repay the loan early. Therefore, it is important to fully understand the terms of any loan you are considering.
Is a personal loan the best option for paying off tax debts?
Mamie, if your credit is good to excellent and you meet the income requirements, you may qualify for a $16,000 personal loan at a great interest rate and terms. A personal loan could allow you to pay off your tax debts and avoid the snowballing interest costs that can come with unpaid tax debts, credit cards, or an IRS installment plan.
Finally, don’t underestimate the mental health benefits you can reap from paying off your tax debt. Some forms of debt can be more stressful than others, and tax debt — with its potential to result in forfeited wages, liens on property, and forfeited assets — is definitely a onerous type of debt. You can rest easier knowing that you owe a personal lender, not Uncle Sam, and that your interest expense won’t keep piling up as you pay off the debt.
You can Review your prequalified personal loan rates in minutes without impacting your balance when using 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 by Credible Money Coach, Published Author and Entrepreneur. He has held leadership positions at Merrill Lynch and Morgan Stanley. He is a recognized expert in personal finance, global investment services and corporate stock options. You find him on LinkedIn.