What to do if you can't pay your taxes

Credit: Flickr user 401K

If you file your tax return on time, but don't have enough money to pay your taxes in full, the IRS's late-payment penalty is 0.5 percent per month until the balance owed is paid in full. It can amount to as much as a quarter of the taxes you owe. You will also be charged interest on the balance owed. Suffice it to say, paying late can get expensive.

But starting this month under the agency's expanded Fresh Start Initiative, the IRS will allow taxpayers who have been unemployed for at least 30 consecutive days or those who are self-employed and experienced a significant drop in income to qualify for a 6-month grace period on the failure-to-pay penalty. People who meeting the eligibility requirements will need to complete a new Form 1127A to seek the penalty relief for 2011.

If you don't make any sort of tax payment, the IRS can levy your wages and even place a lien on your property for the amount of the unpaid taxes, penalties, and interest. Of course, the agency is finally getting the message that you can't get blood from a stone, and as a result has relaxed some of their usual collection practices under the new initiative.

What to do if you can't pay taxes on time

If you can't pay the full taxes that are due, one possibility is to get a loan from the bank or a credit union. Of course, if you can't afford to pay your taxes, then you may not qualify for a loan. You could also ask for a loan from a relative or friend, or tap a home equity line of credit, if one is available. Current interest rates on home equity credit lines are low and repayment terms are flexible.

If you're really desperate, you can pay your taxes using your debit or credit card. But be cautious. Although that option will avoid the IRS penalties for making no payment, you'll pay convenience fees in the range of 2-4 percent of the amount charged. And obviously if you don't pay your credit-card balance in full, you could end up paying hundreds of dollars of interest on the balance at a far higher rate than the IRS charges for installment payments.

How to arrange an online payment agreement

Still, the hard reality for many folks who can't afford to pay their taxes is that they simply can't get the cash. Here are some payment options the IRS offers for people who need to pay over time.

Under the Fresh Start Initiative, if you owe less than $50,000 in combined tax, penalties, and interest and you have filed all required tax returns, you may be eligible to complete and submit an Online Payment Application, or OPA. Taxpayers (or their representatives) can apply online and immediately find out if they qualify. In some situations, you may need to speak with an IRS agent before you are approved for a payment plan, so the OPA application also includes contact information for the agency.

When submitting an Online payment agreement application, there are three payment options:

Pay in full: This avoids additional fees, penalties, and interest for failing to make a tax payment.

Short-term extension: If approved, you could get an extension for up to 120 days to pay and will avoid any applicable payment fees.

Monthly payment plan: If you can't pay your taxes in full within 120 days, you may be permitted to make monthly installment payments. Note that there are strings attached -- you must have filed all of your prior year's tax returns and pay a user fee of $105 ($52 if payments are automatically deducted from a bank account). You'll also pay the IRS interest on the unpaid balance, which is currently an annual rate of 4 percent.

When you request a short-term extension or monthly payment plan, the IRS will send written confirmation within 10 days so you'll know your request has been approved.

Since the IRS charges a user fee for setting up an installment agreement, it may not be the best option if you owe $2,000 or less. Also keep in mind that you have up to five years to pay under the installment agreement and that you'll have to pay all future taxes in full and on time.

You'll incur penalties and interest on the taxes until they are paid off. However, depending on your individual circumstances, the IRS could offer a payment plan at a reduced interest rate. Also, as a condition of the installment agreement, any future tax refunds will be automatically applied against the amount you owe until the balance is paid off.

Image courtesy of Flickr user 401K

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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