Ten Ways To Diffuse A Tax Time Bomb
A large and unexpected tax bill can be devastating to your budget, especially if you don't have an emergency fund or are living paycheck to paycheck. Before you panic, however, you should double-check your math to make sure it isn't merely an error. If the math is sound and you don't have funds to cover the bill, then there is a problem. Ignoring a big tax bill will only increase your pain as the IRS will assume you're evading taxes and unleash the dogs of war upon your assets, wages and accounts. Fortunately, there are ways to diffuse the tax time bomb as long as you address things early.
Flash The Plastic
Credit cards usually cause problems rather than solving them, but in this case they can at least postpone paying your tax bill. As with anything involving plastic, there is a price to be paid. The high rate of interest is a serious stumbling block between you and actually paying off the bill over the following months. You will also incur a convenience fee that varies depending on which third-party company you use to make the payment. If you just need a little breathing room and you have enough available credit, however, credit cards can be a solution. Before you do that, though, see Understanding Credit Card Interest for more.
Beg The Bank
If your credit rating is in good shape, you can always get a personal loan from the bank to cover the bill. The catch is that, if you don't have a strong credit rating, the interest charged by the bank may be just as much as your credit cards. Also, there is the application process to go through and no guarantee of approval at the end. Most banks have streamlined this process with computers, so there is no real harm in checking what terms they will offer you. If the interest rate is low, then take it. See The Importance Of Your Credit Rating for more.
"A" For Effort
Although the IRS isn't quite as kind as your second grade teacher, there is the option of doing the best you can and counting on their mercy. Raid the piggy banks and empty out the sock drawer, and send what you can with your return. You'll get a, "Notice of Tax Due and Demand for Payment" stating how much is left to pay and the penalties and interest they've assessed. The danger here is that whatever arcane method they use to assess penalties may cut deeper than your credit card company or your bank. For some sage advice, see Surviving The IRS Audit.
Dip Into Savings
A big tax bill definitely counts as an emergency so, assuming that you've built an emergency fund for situations like this, it's time to break the glass. You might be nervous about using your emergency fund for taxes and then getting hit by a car and being out-of-pocket for hospital bills with no money saved up, but the fund is there to use in real emergencies rather than keeping it pristine to guard against all the future possibilities. If you don't pay, the IRS might see your emergency fund as evidence of intentional nonpayment of taxes and declare war. That said, be sure to put a priority on recharging your emergency fund as soon as the crises has passed. See Build Yourself An Emergency Fund for more.
Purge Your Portfolio
Being forced to sell assets to cover expenses is never ideal, but you make it work for you in a pinch. You can even reduce your tax bill in the future by carefully selecting the investments you sell. Any loss up to $3000 counts as a realized capital loss and can be used to offset gains from selling investments that have appreciated as long as both sales fall in the same tax year. You can carry forward your excess losses under the capital loss carryover rule for further deduction in the future. Check out Selling Losing Securities For A Tax Advantage.
Crack The Nest Egg
Dipping into your retirement account for any reason is a big decision. There are usually penalties for early withdrawal and you may have to replace the funds in a given timeframe to have it count as a temporary withdrawal. More than the administrative fees and hassle, borrowing from your retirement breaks some of the mystique of a retirement account. If you borrow from it once in a pinch, you're more likely to do so again in the future, leaving you with a depleted nest egg in the end. Using your retirement as an emergency fund may work, but it shouldn't become a habit. Check out Borrowing From Your Plan for more information.
Relationships are complex enough without bringing money into the picture, but desperate times call for desperate measures. Your family and friends shouldn't be used as a last resort because the bank isn't forthcoming and your credit cards are full. If you're in that kind of trouble, you don't want to add the people who genuinely care for you to the list of angry creditors. If, however, there is a family member or friend who you've done financial transaction with before and you both feel comfortable with the loan, then love money may be the simplest and cheapest option.
Take It In Small Doses
If there is no way for you to handle the bill in one go without going insolvent, the IRS does allow you to break it up into installments using form 9456. You will still get penalized and you will need to make the payments on time and in full every month. There is a fee to set up the plan and another fee to get it going again if you default on any of the payments. Adding to the knife twists of fees, the IRS can also put a lien on your property until the bill is paid in full, making it extremely difficult to move or access your home's equity. However, they can't take any collection action while the agreement is in place.
Put It On The House
Taking out a home equity line of credit (HELOC) is a promising course for those who have the option. The interest rates are lower than credit cards and unsecured personal loans, and the interest on a HELOC may be tax deductible. If you default on your payments, however, there is a possibility that you could lose your home. If you can handle the risk and are diligent about the payments, then the HELOC saves you in interest as well as IRS penalties. See The Home Equity Loan: What It Is And How It Works for more.
Take A Time-Out
Using a form 4868 you can get an Automatic Extension of Time To File U.S. Individual Tax Return, but this only applies to the time to get the paperwork in - it doesn't increase the time you have to pay your bill. For that you need a form 1127. This form grants taxpayers a six-month payment extension provided you can prove that paying immediately would cause "undue hardship." You'll need to list all your assets, liabilities, and copies of your budget for the last three months. Simply put, the IRS is extremely picky when granting a payment extension. See Get A Six-Month Tax Extension for more.
Tithe For Next Year's Tax
You can reduce the pain of a tax time bomb by defusing it as quickly as possible. Whether you use a HELOC, love money, credit cards, or some other solution to get rid of this year's bill, you need to take steps towards preparing for big tax bills in the future. Creating an emergency fund is a great idea if you don't have one already, if not for a tax bill than to use against the other shocks life serves up. Keeping up to date with changes in your tax situation is also a long-term solution. By adjusting your withholding as your financial situation changes you can usually avoid the tax time bomb all together.