Tax time can be stressful, particularly if you don't have the money to pay what you owe. While a credit card can be a convenient source for the cash, make sure you understand all the ways it will cost you.
Ideally, you would have enough money withheld from your earnings throughout the year so you wouldn't have to scramble for cash on tax day, says Todd Mark, vice president of education for Consumer Credit Counseling Service of Greater Dallas. But if your savings won't cover the taxes you owe, you have to determine which form of payment will cost you the least.
While taxpayers can pay a large tax bill over time via an installment agreement with the Internal Revenue Service, "some people don't like owing the IRS," says Robbie Hampton, managing partner of Bishop, Hampton & Associates, a certified public accountant firm based in Stockbridge, Ga. For those who'd prefer the convenience of plastic, the IRS makes the process particularly seamless.
The Taxpayer Relief Act of 1997 forbids the IRS from paying credit card transaction fees, so the agency has outsourced the role of collecting credit card payments to three third-party services -- Link2Gov Corp., Official Payments Corp. and WorldPay US. Taxpayers can pay using American Express, Discover, MasterCard or Visa. Payments can typically be made via phone, the Internet or through tax preparation software. The IRS website page "Pay taxes by credit or debit card" provides details and current prices. For taxes due April 15, 2013, the "convenience fee" ranges from 1.89 percent to 2.35 percent of the payment for credit cards. Those using a debit will pay a flat fee of $2.99 to $3.95.
Analyzing the costs
That means a $4,000 tax bill would likely cost you between $80 and $120 upfront to pay by credit card. On top of that, you must pay your credit card issuer interest on the balance. In March 2013, the average credit card interest rate was 14.95 percent (see current average credit card rates). One bit of good news: You can deduct the convenience fee on next year's tax return.
Credit card users can always avoid going through those services -- and paying the convenience fee -- by paying with a cash advance check attached to their credit line. However, you likely won't come out ahead financially because such checks typically come with transaction charges of their own, and cash advances tend to have higher interest rates associated with them than regular card purchases, Mark points out.
Before whipping out the plastic, compare the costs of paying by credit card with the costs of seeking an installment agreement with the IRS. That's what Dana Andrews of Wheatfield, N.Y., did when he had a $15,000 tax bill. After weighing both options, Andrews decided to go with the installment plan. Typically, taxpayers get five years to pay off a debt, and if you owe $25,000 or less, you can likely set your own monthly payment amount as long as the balance is paid off in 60 months, says Michael Rozbruch, founder and CEO of tax negotiation company Tax Resolution Services.
The IRS will automatically accept requests for installment agreements of up to $50,000, and for the first quarter of 2013, its interest rate is just 3 percent -- far less than current credit card rates. The minimum payment is $25. See the online payment application agreement and tax payment options on the IRS website for more details.
Of course, you'll still have to pay interest and late penalties. If you fail to file on time, the IRS charges 5 percent of the amount owed for each month that your return is late up to five months. Once you file, you still have to pay one-half of 1 percent of the amount owed for each month that the payment is late. Once you set up an installment agreement, you get somewhat of a break, as the late penalty drops to one-quarter of a percent per month, Rozbruch points out.
But the costs don't stop there. Interest, compounded daily, must also be factored in. The interest rate, which equals the federal short-term rate plus 3 percent, is set quarterly. In the first quarter of 2012 it was 3 percent, but it's not unusual for the rate to be4 percent or even 5 percent, Rozbruch says. There's also a one-time charge to set up the installment agreement -- $105, or $52 if you agree to have your payments automatically deducted from your bank account. Some low-income taxpayers can qualify for a smaller set-up fee of $43. If you do select an installment agreement, know that you won't receive future tax refunds until your debt is paid off. Instead, the refunds will be applied to the debt.
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Weighing the pros and cons
Some -- including the IRS -- tout using credit cards to make tax payments as a way to take advantage of rewards, such as frequent flier miles or cash back. However, card issuers typically award rewards worth 1 percent of your spending, whereas the third-party convenience fee could top 2 percent. "Taxpayers would likely be paying more to the third party than they would get back for redeeming points," Rozbruch says.
A promotional credit card rate of 0 percent, 1 percent or 2 percent would likely make for a better deal than the IRS agreement. But make sure you would be able to pay the entire amount before the promotional rate expires, and keep in mind that if you are late on a payment, your rate could skyrocket, Rozbruch warns.
Another thing to take into consideration: an IRS installment agreement won't impact your credit, whereas paying by credit card would increase your debt load, impacting your credit utilization ratio and lowering your score. "You can end up with increased interest rates and a reduced credit line," says Mark.
Finally, it's important that you also don't overlook other options. Borrowing from a retirement account, taking out a home equity line of credit and seeking out a bank loan could also provide cash with lower rates and better terms, says Bill Hampton, general partner of Bishop, Hampton & Associates.
Regardless of what option you choose, prepare to have more money set aside to ensure that you don't fall short next year. "Don't just solve your tax problem; make sure you're not repeating it," Mark says.
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