How to Handle an Unexpected Tax Bill in 4 Steps

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This post comes from Beth Braverman at partner site The Fiscal Times

If you’re like most Americans, the process of filing taxes – while painful – typically results in a refund from the IRS.

So far this year, 84 percent of filers have received a refund. The average refund amount this year is just over $3,000.

The percentage of filers receiving refunds from the IRS typically declines as April 15 approaches, because people who owe taxes tend to file returns later. The majority of those who owe money expect a tax bill.

Each year, however, millions of Americans file their taxes expecting a refund; instead, they’re socked with an unexpected tax bill that can be difficult to pay.

It’s worth noting that owing taxes is not inherently a bad thing. People who routinely receive large refunds are overpaying taxes throughout the year and are essentially giving the federal government an interest-free loan. “Tax refunds aren’t just free money, after all,” says Melanie Lauridsen of the American Institute for Certified Public Accountants.

If you’ve done proper tax planning throughout the year, there shouldn’t be any surprises at tax time. However, common reasons for an unforeseen tax bill include improperly filling out W-4s and not withholding enough; a life event, such as an inheritance or a divorce, resulting in an unexpected windfall; or incorrect payments by quarterly filers.

Whatever the cause, receiving a tax bill you hadn’t planned for can be an unsettling event, especially if the amount you owe is large and you don’t have the cash available to pay it out-of-pocket.

Here’s what to do if it happens to you.

Don’t panic

First, make sure you actually owe the amount you believe you owe. Examine your returns from last year to see what changes are resulting in a higher bill and alert your tax preparer so you can work together on fixing the problem. Often a big swing in tax obligations could reflect a mistake made in filling out forms.

If you don’t think you owe a large amount and you did your taxes yourself, if may be worth having a professional check your returns to see if you missed anything (or getting a second preparer to check the work of the first one).

The simplest and easiest way to deal with the burden, of course, is to pay it immediately. If that’s not possible, keep reading.

File your taxes anyway and pay whatever amount you can

Too often, taxpayers who owe money decide not to file until they’re able to cover the costs. That’s the worst possible move, since failing to file can result in fees and accrued interest that can push your obligation even higher. In addition, the IRS can put liens on your home or garnish wages if you’ve made no effort to pay the taxes you owe.

Simply filing for an extension won’t get you off the hook, either. Even if you’re granted one, you still owe your estimated taxes by April 15. “An extension gives you extra time to file, but not extra time to pay,” says Lindsey Buchholz, lead tax research analyst at the Tax Institute for H&R Block.

Paying at least a portion of the bill, even if it’s just a token amount, is a good-faith gesture to the IRS that will not only decrease your obligation, but will also show the agency you’re committed to paying what you owe, tax experts say.

Explore your options to borrow

If you don’t have the cash to cover the bill, you’ll have to find a way to borrow it. Here’s a look at your best options:

  • If you owe less than $1,000, put it on a credit card and pay it off as quickly as possible. If you owe more than that but think you can pay it off within a year, consider opening a new credit card with a 0 percent introductory rate for at least 12 months (if possible, look for one that will give you rewards as well). Even with 0 percent interest, you’ll be charged a fee for paying with the credit card that will cost from 1.87 percent to 2.35 percent of your balance.
  • Sign up for an IRS installment plan. The IRS lets taxpayers who owe less than $50,000 sign up for the online plan, which stretches out payments over up to six years. In addition to modest enrollment fees, the agency charges a variable interest rate (currently at 3 percent). “The rates are actually pretty competitive,” says Mark Steber, chief tax officer at Jackson Hewitt Tax Service.

Beware that if you miss a payment on the installment plan, the IRS can immediately come after you through wage garnishment or liens for the remainder of your bill.

  • For taxpayers with a good amount of home equity, consider using a home equity line of credit or a home equity loan to cover the bill. Rates on such loans, when I wrote this, were 5.07 percent, and HELOC rates were 6.22 percent. Bonus: For any loans under $100,000, you can deduct interest paid on next year’s taxes.
  • If at all possible, avoid borrowing money from or withdrawing from your retirement funds to pay your taxes. Such actions could put your retirement in jeopardy – and potentially trigger additional tax penalties on next year’s tax bill. Another option to avoid is charging the amount due on a high-interest credit card, which is costly and damaging to your credit.

Prepare for next year

Once you have a payment plan, stick to it, and eliminate the debt as quickly as possible. Then take action to make sure you don’t owe a hefty bill next year.

Plug your info into the IRS withholding calculator to see how changing your elections could get you paying the right amount. “For self-employed workers, planning ahead might mean being more concerned and conscientious with making estimated payments, or setting up a segregated account so you can set aside a portion of each payment instead of letting it go into your general funds,” says J.J. Montanaro, a certified financial planner with USAA.

Sit down with a tax planner who can help you see how the money moves you make during the year can keep you from getting another unwanted surprise from Uncle Sam in 2015.

More on The Fiscal Times:

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