Tax Day is rapidly approaching, and the IRS just announced that the interest rates it charges on past-due taxes are increasing. Nobody likes to owe the IRS money, but it's not an uncommon situation -- even if you don't realize it until you fill out your tax return. For these reasons, now is a good time to quickly review what interest and penalties could mean for you if you owe the IRS money.
IRS interest rates are going up
The Federal Reserve has raised interest rates several times over the past year, so it shouldn't be too surprising that the IRS would boost its interest rates as well. After all, the IRS interest rates are based on federal short-term rates, rounded to the nearest full percentage point.
The IRS, which determines its interest rates quarterly, just announced a rate hike for the second quarter of 2018, beginning on April 1. The rate for underpayments and overpayments for individuals will be 5% annually (daily compounding). Rates for corporations are also going up. To put this in context, if you owe the IRS $10,000, you can now expect to pay about $1.37 per day in interest charges while your debt is outstanding.
This is in addition to penalties you might owe
The penalty for paying your taxes late is 0.5% of the past-due balance per month or partial month, up to a maximum penalty of 25%. For example, if you owe the IRS money for two months and three weeks, you'll be penalized 1.5% of the outstanding balance.
On the other hand, the failure-to-file penalty is much worse -- 10 times worse, to be specific. For each month or partial month you file your tax return after the deadline, you'll be assessed a 5% penalty, up to the same 25% maximum.
A couple of things are worth noting here. First, if both penalties apply in a given month, you'll only pay the 5% amount -- not 5% plus 0.5%. Second, notice that both penalties are based on a percentage of the money you owe. In other words, if you don't owe the IRS any money, you aren't financially penalized for filing your tax return late (although you're still technically required to file on time). Think of it this way: If you're owed a refund, the IRS will gladly hang on to it until you're ready to claim it.
An extension won't help you avoid interest
As the April 17, 2018, tax deadline is rapidly approaching, it's also important to mention that filing a tax extension does not excuse you from paying your entire tax liability. An extension simply gives you an additional six months to file your return -- it does nothing to extend your payment deadline.
So, while a tax extension buys you more time to file your return, keep in mind that interest is charged retroactively to the April 17 tax deadline if it turns out that you owe the IRS money.
What it could mean to you
Here's a hypothetical example to put some numbers behind this. Let's say that you prepare your 2017 tax return and discover that you owe the IRS $5,000. You can't afford to pay, so you file your return in April to avoid the costly failure-to-file penalty.
Based on the newly increased 5% interest rate, you'll face a daily rate of about $0.68 added to the balance, and because of the IRS's late payment penalty, you'll also be charged $25 per month (or partial month) until the debt is paid.
So, let's say that you pay the $5,000 debt to the IRS on June 30. This is 74 days past the tax deadline, so you'd owe $50.32 in interest. You'd also have to pay the 0.5% late payment penalty for three months (May, June, and part of April), for a $75 late charge. Between interest and penalties, paying your taxes late would cost you $125.32.
Finally, while you can get out of the late filing or late payment penalties if you show reasonable cause for your tardiness, interest is generally charged no matter what.