How to avoid tax penalties

Short of cash at tax time? Don’t sit back and let the fines build up. There are alternatives!

Tax time is always a stressful time of year. But it’s even more stressful -- and more costly -- when you don’t have the money to pay your taxes. You can end up being hit with penalties and interest payments that significantly increase the amount you owe Uncle Sam, so it’s well worth looking for alternatives. And you do have options such as working out a payment schedule with the Internal Revenue Service. It may be cheaper, however, to borrow the money from a lender. Because tax rules vary based on income and other factors, you should always consult an accountant or financial advisor for advice on your particular situation.

What are the penalties?
The government begins to apply penalties and interest as soon as you’re late with your tax payment. However, the heaviest penalties are for filing late: the IRS charges 5 percent of the amount you owe each month, up to a maximum of 25 percent of the total. So it’s important to file your return on time, even if you can’t pay all your taxes.

If you just don’t have the money, the penalty for paying your taxes late is one-half of 1 percent of the amount owing each month, up to 25 percent of the total amount. In addition, you are charged interest at the government’s current annual rate (7 percent at time of writing) on the unpaid balance, penalties and interest in your tax account. These charges can add up quickly.

Even worse, if you don’t make an effort to pay the taxes, the government can take the money directly, by imposing a levy against your salary or other income. Or it can file a notice of lien against your property that will affect your credit rating.

What you can do
There are a number of ways to avoid or reduce the penalties. These involve alternative ways of paying your taxes or finding the money to pay them.

• Pay installments: If you can’t pay immediately, you can make an arrangement with the IRS to pay off the taxes over a realistic period -- sometimes up to 10 years. However, you’ll continue to be charged penalties and interest on the unpaid portion of your taxes, plus a $43 processing fee.
• Liquidate some assets: You can sell some stocks, bonds or property, or cash a CD to raise the money you need. This will cause some short-term pain but will solve your tax problem immediately.
• Borrow the money you need: The best way to pay your taxes and avoid the penalties may be to borrow the money from a lender. While you’ll have to pay interest and fees on the loan, these will often amount to far less than the penalties the IRS imposes. And you’ll avoid the sleepless nights and damage to your credit that a tax case can cause.

The advantage of using a home equity loan
You can use a personal loan to pay your taxes, with your 401k plan or an insurance policy as security. But if you have significant equity in your home, a better solution may be a home equity loan.

Because it’s secured by your home, this type of loan often carries a lower interest rate than other personal loans, and a considerably lower rate than credit cards. The interest may also be tax-deductible, helping reduce next year’s taxes. The amount you can borrow depends on the equity you have in your home. However, due to the recent rise in house prices, you may have accumulated more equity than you are aware of.

Remember, however, that you are using your home as security for the loan, so the lender could foreclose if you default. Borrow an amount that you can reasonably repay. If that doesn’t cover your entire tax balance, you can make a partial payment and arrange to pay the rest by installments; it will still likely be cheaper in the long run than paying all the fines.

Related Topics:

• Financial Literacy Guide
• Managing your money
• Smarter spending