Aside from the actual stress of filing taxes, most people enjoy the after effects of tax season. The average person receives more than $3,000 in the form of a refund. But then there are those people – typically self-employed contractors – who end up owing the IRS money.
If you’re one of the millions who end up owing money in April, then tax season is anything but fun.
Why Do I Owe Money?
Maybe you’ve never owed the IRS money before and are used to getting a refund on your tax return. In that case, you’re probably shocked, disgusted, or agitated. Confusion is also a pretty common feeling. You may not even know why you owe the IRS money. Doesn’t everyone get a refund?
There’s only one reason you owe the IRS money after filing your taxes: You paid less tax during the previous tax year than you were required (based on your income level). Now, the reason why you paid less than you owed can vary.
If employed by a company, the IRS requires that employers withhold a portion of pay each month to satisfy taxes. The amount that’s withheld is determined by your W-4, which was filled out when you started the job. If you owe money, you didn’t instruct your employer to withhold enough money from your paycheck.
Typically, though, people who owe money are self-employed and/or receive a lot of 1099s for contract work. If you’re self-employed, then you should be paying quarterly estimated taxes throughout the year. But even with paying estimated taxes, it’s not always easy to land on the right number. Thus, the reason you owe money.
Here Are 7 Things You Need to Know when you owe the IRS money
Most people panic when they come to the realization that they owe the IRS. And while it’s easy to feel pessimistic about the situation, it’s important that you pick yourself up and get a game plan together.
The sooner you act, the better off you’ll be. Here are some things you need to know:
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Don’t Skip Filing Your Taxes
When you see that you owe, say $1,500, your first thought may be to stop the process altogether and not file your return. This is a big mistake and one that every tax expert will tell you not to make.
“You’re so much better off sending the return in or filing a valid extension. Let’s say you owe $20,000 and you usually get a refund,” says Cari Weston of the American Institute of Certified Public Accountants. “Don’t think to yourself, ‘I don’t have the time.’”
The repercussions for not filing are steep. You’re better off filing and not paying than not filing at all. Not only will you have to pay the amount you owe, but you’ll also be slapped with a penalty. Furthermore, penalties begin to accrue interest starting on April 19. What are the financial ramifications?
“Well, you end up paying a penalty on the amount you owe at 5% per month (4.5 % for not filing and 0.5% for not paying),” explains Stephanie Morrow of LegalZoom. “The total penalty for failure to file and pay can eventually add up to 47.5% (22.5% late filing, 25% late payment) of the tax owed. Interest, compounded daily, is also charged on any unpaid tax from the due date of the return until the date of payment.”
The moral of the story? Even if you can’t pay the amount you owe, it’s still important that you file your return.
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Make Sure You Actually Owe the Money
Once you file your tax return, it’s important that you make sure you actually owe the money. This is especially true if you filed your own taxes. It’s easy to make mistakes, add the same income twice, or forget to take an obvious deduction.
Even if you’ve hired an accountant to file your return for you, they’re anything but perfect. Accounts often work 12-plus hours per day, seven days a week during tax season. They’re tired and mistake-prone. Double-check their work and don’t be hesitant to ask for clarification before signing the return. If a mistake is made, it ultimately comes back to you – not them. Stand up for yourself; nobody else will.
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Ask for Leniency
If you failed to follow the advice in the first step and owe a penalty, you may be able to get out of it by asking for leniency.
“If you have a history of paying on time, you can ask if you can please waive the penalty,” Weston says. “The IRS will look at your history, and if you haven’t previously had a penalty, they have to waive the penalty the first time you ask. They won’t tell you that.”
Even if you don’t qualify for this waiver, you may ask for the penalty to be dropped based on probable cause. This won’t always work, but it’s worth a try.
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Set Up a Payment Plan
If you owe less than $50,000 to the IRS in individual income tax, or less than $25,000 in payroll taxes (for businesses), then you may qualify for a payment plan or installment agreement that allows you to gradually pay off your tax debt over a number of months.
“The IRS is often willing to grant installment payment plans (starting at just $25 a month), and applying for one can help you avoid more serious consequences like liens and levies,” E-File.com explains. “Installments accrue both interest and contain setup fees so it is not without cost.”
Make sure you review all of the details on payment plans and installment agreements and consult a tax advisor or IRS specialist before going this route. Because of the aforementioned interest and fees, it doesn’t always make sense.
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Negotiate With the IRS
Believe it or not, you can actually negotiate with the IRS. Whether or not they budge is up to them, but it’s definitely a realistic option worth pursuing if you’re in dire straits.
The negotiation tactic the IRS typically uses is an Offer in Compromise (OIC). The problem with an OIC is that you usually have to offer at least as much as your net worth (everything you own minus your outstanding debts). The problem is that this is a lot like bankruptcy and should only be used if you have no other options.
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Pay the Right Way
So, let’s say that you’ve exhausted all of your options and you end up owing a chunk of change to the IRS. Now comes the time when you have to decide how you’ll pay. Word of caution: be extra careful here. The last thing you want to do is exacerbate the problem.
If you don’t have any money in the bank, it can be tempting to just put your tax bill on the credit card. This is a huge mistake and will haunt you for years to come. Don’t do it! Other options you may consider include borrowing against your home equity, taking out a second mortgage, or picking up some other type of loan. Again, not good ideas.
It’s best to sell things you own (such as a car), increase your income, or pick up a second job/overtime to make some more money. The last thing you want to do is put yourself in more debt – and that’s exactly what one of these high-interest loan vehicles will do.
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Create a Plan for Next Year
While it won’t help much with the tax debt you currently owe, now is a great time to create a plan for next year. By updating your W-4 or running projections for accurate estimated taxes, you can get much closer to the zero-point where you don’t owe anything and the IRS doesn’t owe you anything, either. This is the ideal place to be.
If you’re an employee for a company, this means revisiting your W-4 and reducing the number of allowances you take. If you’re self-employed, this means increasing the amount you pay each quarter to account for last year’s deficit and any pay increase you’ll receive this year. (You need to know what tax bracket you’re in to do this more accurately).
Stay On Top of Your Finances
Few things are worse than coming into April expecting to get a couple thousand dollars back, only to find out that you owe a few thousand dollars. If you’re already living paycheck to paycheck, or only have a little in savings, this sort of surprise can put you in a financial tailspin.
The good news is that it’s pretty easy to correct this problem for the future. Find a way to pay the money you owe the IRS and then make sure you adjust your W-4 and/or make more accurate estimated payments this year.
The goal for next year should be to get as close to a zero dollar refund as possible. But at the very least, you don’t want to owe anything.
