Should You Use a Loan to Pay Your Tax Bill?
Filing taxes may not be an enjoyable task, especially if you end up paying Uncle Sam instead of getting a refund. A U.S. Government Accountability Office report estimates that 21 percent of taxpayers, or about 30 million Americans, may end up owing the IRS when they file their 2018 returns because they didn't withhold enough tax from their paychecks throughout the year.
If you've been hit by a surprise tax bill that you're struggling to pay, you could use a loan to cover it, if you qualify.
"If you owe money in taxes and find yourself short on cash, don't panic," says Billy Lanter, fiduciary investment advisor at Unified Trust Co. in Lexington, Kentucky. "There are several options available to consider, but some are certainly better than others."
Although you can use a loan to pay taxes, weighing whether that makes sense for your finances is important.
[Read: Best Home Equity Loans.]
IRS Payment Plans
Before you take on a loan, talk to the IRS about a payment plan.
"To set up an installment agreement, the IRS will look at what you owe and come up with a minimum payment," says Josh Zimmelman, owner and founder of Westwood Tax & Consulting in New York City. A setup fee applies to long-term installment plans, and penalties and interest continue to accrue on the balance until your tax bill is paid in full.
Interest accumulates on unpaid taxes from the due date of your return -- compounded daily at the federal short-term interest rate, plus 3 percent. That's currently 6 percent, but rates can change quarterly. A failure-to-pay penalty of 0.5 percent applies for each month or part of a month the bill is unpaid, up to a maximum of 25 percent. Though, if you are on a payment plan, that amount may be reduced.
While calculating the interest is fairly straightforward, determining penalties depends on whether you've filed your taxes late. If you filed on time and are ready to set up a payment plan, you can choose between a short- or long-term payment option.
What Kinds of Loans Can You Use to Pay a Tax Bill?
Although you can finance your tax bill directly with the IRS, you could save if you qualify for a loan with lower interest and fees. Loan options for paying your taxes include:
-- Secured and unsecured personal loans
-- Home equity loans
-- Business loans (if you owe business taxes)
"You can use a personal loan for almost any legitimate purpose, including to pay your taxes," Zimmelman says.
With a personal loan, you may be able to borrow anywhere from $1,000 to $100,000, depending on the lender's loan limits. Just keep in mind that even if a lender has a higher limit, the amount you qualify to borrow is based largely on your credit score, income and debt.
A home equity loan may be another option to consider, and in some cases, it could be a more attractive choice than a personal loan. Taxpayers with good credit and home equity may qualify for an interest rate that is lower than IRS interest rates and penalties, Lanter says.
But there is a caveat to using home equity to pay off a tax bill.
"The Tax Cuts and Jobs Act of 2017 made some changes in this area," Lanter says. "Interest paid on a home equity loan or home equity line of credit used for personal expenses usually means no tax benefits."
In previous years, the interest on these loans was tax-deductible, regardless of how the money was used. Tax reform makes interest deductible only when a home equity loan is used for home improvements.
If you owe business taxes, taking out a business loan may be preferable to a personal loan. A business loan could allow for higher borrowing limits and for deducting interest paid on the loan as a business expense.
[Read: Best Personal Loans.]
Benefits of Using a Loan to Pay Taxes
Taking out a loan to cover a tax bill has some upsides. In addition to interest savings, a loan could offer clarity of terms and a less risky way to pay tax debt.
"Taking a loan to pay taxes may not sound all that appealing, but it's preferable to having the IRS garnish your wages or file a tax lien against your property," Lanter says.
The IRS can take both of these measures if a federal tax bill goes unpaid. Wage garnishment won't happen right after missing the tax deadline, but it could if a few months have passed and you haven't set up a payment plan.
Loans can offer a more straightforward solution for tax debt than IRS payment plans. IRS interest rates can change each quarter, and your failure-to-pay penalty increases every month until you reach the cap. Your overall payment plan cost with the IRS can be more difficult to pin down than a traditional personal loan that outlines your total finance charges from the start.
Moving your tax debt to a private loan is less risky as well. If you have an unpaid tax bill, the IRS can garnish your wages without first getting a judgment and may be able to take more than a regular creditor can.
Drawbacks of Using a Loan to Pay Taxes
Before applying for a loan, consider the choice from every angle.
"While getting a loan to pay a tax bill is an option, there are definitely downsides that come along with this," Lanter says. "You've taken care of the IRS issue but potentially created additional problems."
Consider your budget. Lanter says that if a new loan payment eats into what is already a strained budget, that could increase your likelihood of default. This may be particularly true, he says, if you've had to adjust your tax withholding to avoid a bill at tax time next year.
"Paying off your new loan may require some lifestyle changes to ensure you can meet your obligations," Lanter says. You don't want to run the risk of defaulting on a loan, as defaults can stay on your credit report for up to seven years from the date of first delinquency.
A loan also might not lead to savings compared with an IRS payment plan, depending on the loan type, lender and rate you qualify for. Personal loans could reach interest rates of 36 percent or higher.
With a home equity loan, your home is on the line as collateral. If you default, the lender could foreclose on it.
Additionally, applying for a loan can result in a slight ding to your credit score because inquiries for new credit show up on your credit report. The good news is that if you're rate-shopping for home equity or personal loans, multiple inquiries may be treated as a single inquiry for credit-scoring purposes.
[Read: Best Small Business Loans.]
Consider Loan Alternatives for Paying Taxes
Using credit cards, withdrawing from retirement accounts, or borrowing from friends or family are alternatives to an IRS payment plan or private loan. But these alternatives can come with their own problems.
A credit card with a zero percent introductory APR offer might have interest savings, but there's a hitch to that. "You'll likely get stuck with an additional processing fee if you pay by credit card," Zimmelman says. Loans don't have this fee.
As of 2019, the processing fee to pay your tax bill with a credit card ranges from 1.87 to 1.99 percent of the payment amount. On a $5,000 tax bill, that adds up to between $93.50 and $99.50. At a minimum, you'll be charged a $2.50 fee to pay with your card.
Of course, if you can afford to pay your bill in full when taxes are due, cash is the cheapest payment option. Even if you're earning cash back, miles or points on your credit card transaction, the processing fee could easily wipe out any rewards value you're getting. And the introductory rate doesn't last forever: You'll pay interest on any balance that remains after the introductory period.
Withdrawing money from your retirement account, either in the form of a taxable distribution or as a loan, in the case of a 401(k), may be an option you're considering to pay your surprise tax bill. The benefit is that you're paying the money back to yourself, but there are consequences.
"Pulling funds out of a retirement plan can be incredibly costly and should be viewed as an option of last resort," Lanter says. Depending on the account and whether you're taking a distribution or a loan, you could face a 10 percent early withdrawal penalty and pay ordinary income tax on the money.
You could avoid those penalties with a 401(k) loan, but only if you repay the loan on schedule. If you were to leave your job, the loan would be payable in full, and if you didn't pay, it would become a taxable distribution. Not to mention, taking money from your retirement account means it doesn't have an opportunity to grow.
"When taking into account the taxes due on the distribution, the 10 percent early withdrawal penalty if you're under age 59 1/2 and the impact of losing compound interest years, this is likely the most expensive option available," Lanter says.
Borrowing from friends and family may be another possibility that could be less costly.
"Most likely, they won't charge you interest, or at least they'll charge you a more reasonable rate than you'd get offered at a bank or through a credit card," Zimmelman says. "The downside is that mixing finances with friendship can put a strain on the relationship, especially if you aren't able to pay them back in a timely manner."
Whatever you do, don't skip paying your taxes altogether.
"The longer you wait to pay your delinquent taxes, the larger the interest charges and penalties will be," Zimmelman says.
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