IRS Debt: Compound Interest

Hello internet, after a short hiatus I am back to share stories about budgeting concerns. Today I wanted to share a cautionary tale about owing money to the IRS. This is one of the worst budget killers in my opinion because of the way they structure the payments.

Last week the issue of taxes came up at work again. One of my coworkers found out I used to prepare taxes for soldiers when I lived in Germany, and so asked for some hints. She began by saying “my taxes are a mess and I just need to figure out a better way.” Come to find out, in a previous tax season she ended up owing around $3,000 at the end of the year and did not have that amount of money saved up to pay the bill. Therefore, she asked the IRS for a payment plan. Sounds reasonable right?

Well, here is what you need to know about the IRS and payment plans. The IRS compounds interest daily. Yes you read that correctly, interest is compounded daily. That means that the amount you owe the IRS quickly becomes more than the original debt.

In the case of my coworker, even though the IRS asked for a monthly payment of approx. $400 she never seems to catch up.

Lets do the math for this using very simple numbers for interest.

Day 1: 3,000 x 3% = 90 New Total 3,090

Day 2: 3,090 x 3% = 92.70 3,182.70

Day 3: 3,182.7 x 3% =95.48 3,278.18

We are only 3 days into the math and you can see that $278 of interest has been added to the bill. And the reality is the interest rate changes according to market conditions. I looked for a historical chart and found that the interest rate for this year is actually at 6% last year was 5% and the highest I could find was from 2001 at 9%. At these rates it becomes very difficult to ever pay off the debt.

Keep in mind there are more complex rules in play to get to this point of compounding interest and I would tell anyone what I told my coworker. Consult a tax expert. They should be able to offer some helpful ways to get the debt under control.

However, what I wanted to bring to light from a budget perspective is, make sure your tax deductions are correctly aligned and your employer is withholding the correct amount.

What I do to make sure this happens is I take my total taxes due (not refund amount or amount owed) and divide that by the pay periods in the year. On the 2018 tax form this is line 63. Most people look line 76a for refund or line 78 for amount owed. These numbers are simply a representation of how well you balanced your tax payments during the year. Line 63, total tax is what you actually owe when all the deductions and income are calculated.

If the number I find is not the same or close to what my employer is withholding I adjust my W4 so that I don’t end up with a huge balance at the end of the year. I know it might stink to get less in your check each pay day but it is sure better than owing a lot at the end of the year and risk a payment plan with interest compounding daily.

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