What happens if you complete your tax return and find that you can't pay the amount you owe?
This isn't supposed to happen. You're supposed to pay income taxes gradually throughout the year so that in April you won't owe much or will even be entitled to a refund of overpaid taxes. Employees have income tax withheld from their paychecks. Self-employed taxpayers pay quarterly estimated taxes directly to the Internal Revenue Service (IRS).
But sometimes your life situation changes or an unusual one-time event occurs during the year. When you prepare your annual return, you may get an ugly surprise—you owe hundreds or thousands of dollars that you didn't expect and simply don't have.
While this isn't a good situation to be in, it's not the end of the world. There are a number of ways to resolve it.
- When you do not pay your taxes by the due date, you will start to accrue interest and penalties on the outstanding amount.
- As time goes on, you may be subject to liens on your property or garnishment of your wages.
- In the most extreme tax evasion situations, you may even be subject to up to five years in jail.
- Be sure to file your tax return on time, even if you can't pay your tax liability at that time, to avoid additional failure-to-file penalties.
- In order to pay your tax bill on time, you could charge your liability to your credit card for a convenience fee or apply for a debt consolidation loan.
- You can also withdraw from your existing savings such as your emergency fund, a HELOC, or a retirement account.
What Happens If You Don't File or Don't Pay
If you find yourself in trouble, you do not want to skip filing your tax return or fail to pay your taxes altogether. The government has the authority to forcibly seize your assets if you don't try to make good on your income tax liability. In the most extreme situations, you may be subject to jail time.
There are a number of scenarios that can lead to penalties and interest charges. The two main ones are filing your tax return late and paying your taxes late.
Due to Hurricane Ida, some residents and business owners in Louisiana and parts of Mississippi, New York, and New Jersey have been granted extensions on their deadlines for filings and payments to the IRS. Most relate to upcoming due dates for quarterly filings and payments. For details, go to the IRS's "Tax Relief in Disaster Situations" page and click on "2021."
Filing Your Taxes Late
It is important to note that filing this form does not give you an extension on the time to pay your tax liability. You're still expected to send any money you owe by the deadline.
Even if you file a Form 4868, you will need to be certain that your tax liability has been paid (or more conservatively, overpaid, with a refund due at the time you actually file your return).
If you file your tax return late—or fail to file at all—you will be subject to failure-to-file penalties. These charges accrue on returns that have not been filed by the due date (or extended due date, if you've filed a Form 4868).
The charges accrue at a rate of 5% of the unpaid taxes for each month or part of a month that a tax return is late. The charges max out after five months, at which point the failure-to-file penalty is 25% of the unpaid tax liability.
If your return is filed more than 60 days after the due date (or extended due date), the minimum failure-to-file penalty is $435 or 100% of your total tax liability (for tax returns with a due date after Dec. 31, 2020), whichever is smaller.
As you can see, filing late does not pay off, with or without an extension. Even if you do not have the funds to pay your outstanding tax liability by the due date, you should still file your tax return so you don't incur extra failure-to-file penalties on top of failure-to-pay penalties and interest.
Paying Your Taxes Late
You might be tempted to send in your tax return but not pay the money you owe. If you fail to pay your taxes by the due date, you will begin to accrue interest and penalties on the outstanding amount.
The interest rate for failure-to-pay is the federal short-term rate plus 3%, compounded daily after the due date (whether or not you filed an extension of time to file your return).
The failure-to-pay penalty charge is calculated at a rate of 0.5% of the outstanding tax liability for every month the debt remains unpaid, up to a maximum of 25%. If you have not filed your tax return and have not paid your tax liability, both failure-to-file and failure-to-pay charges are applicable. In this case, the charge each month is a maximum 5% (4.5% for failure-to-file and 0.5% for failure-to-pay).
The maximum penalty for failure-to-file and failure-to-pay is 47.5% of your total tax liability (22.5% for late filing—maxed out after 5 months, and 25% for late payment—maxed out after 50 months).
At a certain point, the government will issue you a letter demanding payment for your unpaid tax balance. If you ignore this letter, the IRS may file a Notice of Federal Tax Lien to alert creditors that the IRS has a right to your personal property, real estate, or other assets. A lien secures the government's interest in your property.
If the debt goes unpaid for much longer, the IRS may issue a levy. An IRS levy initiates the legal seizure of your assets in order to satisfy your outstanding tax debt. Levies come in many forms and may include garnishing your wages via your employer, seizing your assets directly from a bank account, or seizing and selling your property such as a vehicle or a home.
In the most extreme cases, the IRS may pursue criminal charges against you for tax evasion. Deliberately avoiding paying your tax liability, more commonly referred to as tax evasion, is a serious crime with a penalty of up to five years in jail.
Although this final step is often reserved for the most serious tax evasion cases with large outstanding balances, it is best to err on the side of caution. If you get an initial letter for late payment, set up a plan with the IRS to get your taxes paid as soon as possible.
Options to Help You Pay Your Taxes
Here are a few ways to get you out of your predicament.
For a convenience fee of about 2%, you can charge your tax liability to your credit card. You could also apply for a debt consolidation loan from a bank or credit union.
If you choose one of these options, you'll have made good with the government, but you'll be shifting your debt to an expensive source. Unless you have a credit card with a very low annual percentage rate (APR) or are able to secure a personal loan at a very low interest rate, you might be making your long-term situation worse.
For example, if you owed $5,000 in taxes, the convenience fee to charge this amount to your credit card would amount to about $100. If you had to carry that $5,100 balance on your card for a year at, say, 20% APR, that would add another $1,020 to your bill, bringing the total you owed to $6,120.
Request a Payment Extension
Filing a six-month tax-filing extension using Form 4868 won't help. This extension only gives you more time to file your paperwork; it doesn't give you more time to pay what you owe.
Filing your return on time can help minimize the penalty and interest charges assessed by the IRS. The IRS's late payment penalty is 0.5% per month, up to a maximum of 25%; the late filing penalty is 5% per month, up to a maximum of 25%. So simply filing your return on time can save you a substantial amount in penalties.
If you believe you have a legitimate case due to undue hardship, you can file Form 1127 to request a six-month payment extension. Along with this form, you'll have to submit a statement of all your current assets and liabilities and an itemized statement of all the money you've received and spent in the last three months.
The IRS rarely grants payment extensions, and it will only be granted if you can demonstrate undue hardship. If you just bought a 60" flat-screen TV last month because you had no idea you were going to owe $5,000 in taxes, you're not going to qualify for a hardship extension.
Apply for an Installment Agreement
If you think it will take you more than a few months to pay your tax liability, consider applying for an installment agreement. You can apply online at IRS.gov or by mail using Form 9465-FS.
An installment agreement can prevent the IRS from taking enforced collection action. You'll still owe penalties and interest, but your monthly payments let the IRS know that you intend to make good on what you owe.
Borrow From Yourself
If you have an emergency fund, this is a good time to dip into those savings. You can use your emergency fund as an interest-free loan to yourself to pay off your tax bill and then start replenishing your fund with each paycheck.
If you own a home and you have enough equity, another way to borrow from yourself is with a home equity line of credit (HELOC).
These loans have relatively low interest rates compared to credit cards and personal loans. The downside is that your house serves as collateral. Defaulting on a home equity loan or HELOC is like defaulting on your mortgage—it can cause you to lose your house.
However, borrowing money this way will turn the large lump sum you owe the IRS into a manageable monthly payment to a mortgage lender.
Another option is to borrow from a retirement account like a 401(k) or IRA. Because retirement accounts have tax advantages, withdrawing money from them can trigger a tax liability, including a 10% early withdrawal penalty, if you don't follow protocol. It also damages your retirement savings plan.
Anticipate Late Fees and Penalties
Unfortunately, the IRS is going to charge you interest and penalties on any amount you pay late. Like running a balance due on a credit card, these charges are going to make it harder to pay what you owe.
The more you're able to pay on time, the less interest and penalties you'll be assessed.
The IRS will eventually send you a bill, but you don't have to wait to get the bill to make additional payments.
Pay what you can when you file your return, then send in whatever additional payment you can afford each payday using Form 1040-V.
The Bottom Line
Whatever you do, don't ignore the problem. The government has the authority to forcibly seize your assets if you don't try to make good on your income tax liability. The IRS can freeze your bank accounts; garnish your wages; seize physical assets, such as your car; and place a lien on any assets you own, including your home.
If you find you can't pay what you owe, go ahead and file your return and pay what you can. Then work with the IRS, perhaps with the assistance of a tax professional, to formulate a plan for paying the balance of your tax bill over time.