What should you do if you finish your taxes and discover you owe more taxes to the IRS than you can afford to pay?
It’s bad enough not to get a tax refund you may have been expecting.
Finding out you owe a lot of money is worse. The last thing you want is to get into trouble with the IRS.
Fortunately, you can stay in the good graces of the IRS and pay off or resolve that tax bill, if you follow these steps:
1. Make sure you really owe the money
If you owe a lot more tax than you expected, find out why.
Read your completed return carefully and look for errors. It’s easy to add the same income twice, or to forget an important deduction.
If you expected to qualify for a deduction or credit, and your tax return doesn’t show it, make sure you answered all the questions correctly.
One missed question or checkbox can cause you to miss out on tax benefits you may be entitled to.
Another way to determine if something is amiss is to compare this year’s return to your tax return from last year. If your tax situation has not changed drastically, but your tax bill has, find out why.
If you owe money because you received a letter from the IRS, don’t automatically assume the IRS is correct.
They make mistakes, too. Call or write to the IRS for clarification.
If you still don’t understand the problem and it’s a significant amount of money, seek professional help.
2. Minimize penalties and interest
Large tax bills are worse when you pay penalties and interest on top of the original amount owed. You can minimize penalties and interest in three ways:
Exceptions to underpayment of tax penalties
If you underpaid your taxes this year, but you owed considerably less last year, you generally don’t pay a penalty for underpayment of tax if you paid or had withheld at least as much as you owed last year, and you pay by the due date this year.
Enter last year’s tax liability, so TaxAct can determine if the safe harbor rule reduces your penalties and interest.
You may also be able to reduce your penalties and interest using the annualized income method if you received more of your income in the latter part of the year.
Ask for an abatement of penalties
The IRS often reduces or removes penalties and interest on the penalties if a taxpayer writes a letter explaining the situation.
For example, if you had an unusual tax event, you made an honest mistake, or you or your spouse had a serious illness, the IRS may waive the penalties.
Be sure to ask for an “abatement” in your letter.
Pay as quickly as possible
If you owe tax that may be subject to penalties and interest, don’t wait until April 15 (April 18, 2016 for 2015 taxes) to file your return.
Send an estimated tax payment or file early and pay as much tax as you can.
3. Ask for an installment plan
If you can’t pay the tax by the time it is due, don’t avoid the bill. It will only get worse. File Form 9465, Installment Agreement Request, to set up installment payments with the IRS.
The IRS must allow you to make payments on your overdue taxes if you owe $25,000 or less, you can show that you cannot pay the amount you owe now, you can pay off the tax in three years or less.
You must also agree to comply with the tax laws, and you or your spouse must not have had an installment agreement with the IRS in the past five years.
4. Offer in Compromise
You’ve probably heard ads for experts promising to help you settle your IRS bill for less than you owe. It’s true that the IRS will negotiate back taxes through an Offer in Compromise (OIC).
However, you’ll have to offer at least as much as your net worth – everything you own, reduced by your debts. An OIC is a lot like bankruptcy – you should only use it as an extreme last resort.
What not to do
Don’t put your tax bill on a high-interest credit card
The IRS charges a far lower interest rate, which means you can spend more of your money paying off the balance, not just keeping up with interest.
Don’t take money out of your retirement accounts to pay a tax bill
You may owe a penalty, in addition to income taxes, on the amount you withdraw. By the time you pay the penalty and income tax, you won’t have as much left to pay your previous tax bill as you thought.
Besides, retirement accounts are for retirement!
Finally, if you owe the IRS a good deal of money, don’t panic!
If you play by the rules, stay in touch, and are scrupulously honest, the IRS can be a fairly reasonable creditor.
Some IRS personnel can even be very helpful. Do everything you can to resolve and pay off your bill, and they won’t be your creditor for long.