If you’re one of those who owe and don’t have the dough, you may be tempted to pull out a credit card — but is that the wisest choice?
Using a credit card to pay a tax bill is not recommended, says David Jones, president of the Fairfax, Va.-based Association of Independent Consumer Credit Counseling Agencies. “However, it’s better than using your 401(k) plan,” he says. “It’s also a better option than not paying your tax bill at all because the penalties of paying your taxes late are relatively severe.”
Consider this: If you fail to file your taxes, you can be hit with a penalty of 5 percent of the amount owed for each month or partial month that your return is late, up to five months. On top of that, you must pay interest on the amount that’s due. The Internal Revenue Service determines the interest rate every three months, which is the equivalent of the federal short-term rate plus 3 percent. For the second quarter of 2010, beginning April 1, that’s 4 percent. Taxpayers could also be hit with a penalty of 1/2 of 1 percent of the tax owed for each month or partial month that payment is late.
You can easily avoid the 5 percent penalty for filing late by simply sending your tax return in on time, even if you don’t send in a dime. But when it comes to determining the best way to pay what you owe, consider the following carefully:
IRS may offer the best terms
While many people have a fear of the tax man, “the IRS is cognizant of the economic problems that exist right now and is willing to be more flexible because of that,” says Eric Tyson, author of a book on personal finance and the founder of the personal finance website, Erictyson.com.
That means it it is likely to work with you to come up with a payment plan that you can afford. If you owe $25,000 or less, the IRS will automatically grant you an installment agreement, which means you can determine how much you can pay each month. You’ll then be expected to pay down the balance accordingly. While it may be tempting to agree to pay a lesser amount each month than you can afford, you’ll pay for it in long run because the interest and late payment penalty fees don’t stop. “The IRS knows if they let you drag it out longer, they’re just going to get more interest and penalties,” says Patricia L. Cosentino, a certified public accountant and attorney in Oak Lawn, Ill. If you owe more than $25,000, you may still be able to get an installment agreement, but you’ll have to disclose personal financial information to the IRS first. Then, it will decide how much you can afford to pay each month, Cosentino adds.
When choosing between the installment agreement and a credit card, look first at the interest rates you’re being offered. With an installment agreement, taxpayers typically won’t pay more than 7 percent or 8 percent of the balance in interest and fees, Cosentino says. Compare that to the national average credit card interest rate, which is currently 14.70 percent, and the IRS plan comes out ahead.
Another payment option is a personal loan with a bank or credit union. Not only may you get a lower rate, but that rate will likely be fixed, unlike the IRS interest rate and a credit card’s interest rate, both of which may change.
Credit cards cost more
Some people may have the money to pay their tax bill, but they think paying by credit card will be more convenient or allow them to earn credit card rewards. However, convenience comes at a cost.
The IRS allows only a select group of companies to process credit card payments, and the payoff for doing so is to collect up to tack on an extra 2.49 percent of your payment as a processing fee. Unless your card is offering rewards of more than 2.49 percent of the balance charged, you’ll take a loss if you pay by credit card rather than simply writing out a check.
You can also use one of the cash advance checks your credit card company sends you, but the fees associated with those are often even higher. In fact, according to the 2009 Credit Card Survey by Consumer Action, cash advance fees could be as high as 5 percent of the balance.
Charging a large tax bill could impact your credit score
Depending upon how large your tax bill is and the size of your credit limit, charging a hefty amount can bring your credit score down. “Charging a large tax bill could more easily push you into a situation where you get hit with extra fees on the card for going over the limit or getting behind on payments,” says Tyson. Not only that, but one factor that goes into calculating a credit score is the balance-to-limit ratio, or credit utilization ratio, which compares the amount of credit a consumer has available to the amount of debt he has. If you charge a large tax bill, you’ll have a higher utilization ratio, which could negatively impact your credit score.
Despite the cons associated with paying taxes with a credit card, some may still choose to do so because they’d rather deal with their credit card company than the IRS. Others may just want to have the bill with the IRS settled immediately, and a credit card affords them the opportunity to do so.
If you do decide that you want to use a credit card to pay your taxes, here’s some advice:
- Be wary of promotional rates. Check the terms of all of your credit cards to determine which one will cost you the least over time, Jones suggests. If you use a card with a promotional rate, determine if you can pay the entire balance off during the promotional period. If not, find out what the rate will rise to and determine whether you’ll pay less in the long run using a different card.
- Pay the balance quickly. Even if you have a low interest rate today, that doesn’t mean you’ll have that same rate tomorrow. “The deal as it appears on the credit card could change over time,” says Tyson, whether it’s because you are late with a payment or because the credit card company decides to arbitrarily raise rates.
- Consider credit limits. The interest rate isn’t the only thing to consider. If you know you won’t be able to pay off the tax debt quickly, consider using a credit card with the highest credit limit. The more unused credit you have, the higher your credit score, so charging a tax bill of a couple of thousand dollars could have the reverse effect. By using a card with a higher credit limit, you’ll be better able to protect your score.
However you plan to pay your tax bill, try to pay it within a year because you don’t want to still be paying it this time next April. If that seems like a difficult task, consider seeking financial counseling, Jones advises. “Anybody who has to use a credit card to pay a tax bill is in a serious financial situation,” he says. “A counselor can tell them how to change their spending habits and improve their overall financial picture.”
See related: Beware of IRS tax bite that may follow canceled debt, Don’t use 401(k) to pay back taxes, Paying small business taxes with plastic, Are credit card rewards taxable?, How and when to use plastic to pay your taxes