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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Budgeting and the Tax Debate

Monday was officially the deadline to file taxes for 2018 so of course there were several conversations in the office regarding this topic. The main debate was on the topic of maximizing a refund vs. trying to break even by balancing withholdings from paychecks. At first blush this may not appear to be a budgeting topic, but trust me it is.

The goal of taxes from an IRS standpoint is to have the taxpayer be as close to paying the correct amount of taxes by the end of the year as possible. When I took taxes as part of my accounting degree the professor drilled this concept into our heads. He always said, “If you get a refund at the end of the year that means you just gave the government an interest free loan.”

Okay this is a fair point, especially from an academic standpoint. However, a classmate countered with “I know it is an interest free loan but I do not have the discipline to set aside money. I let them hold on to it and at the end of the year I get a little bonus to splurge on something, maybe a vacation.”  

From a budget perspective tax withholding can have a significant impact. On the one hand, if you keep as close to the actual amount owed as possible you can maximize the amount of money you control. This can help pay bills. Under these circumstances you have to budget the extra money and save it if you want to splurge, like my schoolmate.  I can hear her now “Boring.” In my case I am usually within +- 100 of balanced. It is difficult to be exactly on target. The closest I ever got was owing $15.

On the other hand, if you like the feeling of a yearly bonus tax refund time is a favorite time of year. Saving a little each paycheck to finally add up to the amount it would take to go on a vacation does not give the same rush as getting a big sum all at once on a refund check. You still saved, you just tricked yourself into doing it.

The other benefit of having more taxes withheld from paychecks is you have a cushion when you unsure how much you will owe at the end of the year. It might be better to over withhold than to face a huge tax bill at the end of the year. Especially, if you don’t have the money when the bill comes due.  

I used to volunteer to do taxes for soldiers when I lived overseas. Some of the common reasons people would end up owing money without realizing why are:

  • You and your spouse have jobs, the pay is in a specific tax bracket. Add the income together at the end of the year and now you are in a new tax bracket.
  • Soldiers retire, get new jobs, earn retirement pay, and when all the income is added together at the end of the year, new tax bracket.
  • Forgetting to change deductions when kids leave home and they start claiming themselves on their own taxes.
  • Forgetting to change deductions when marital status changes.
  • Not realizing that you have to pay quarterly taxes on side jobs. This got the personal trainer I worked with.  Taxes for self-employed people are a bit complicated.  People don’t realize that their employer kicks in a certain amount. When you are self employed you pay both parts.

What school of thought are you from; Do you prefer to balance the taxes and keep your money throughout the year?  Or do you prefer to get the refund at the end of the year? The debate among my colleagues goes on 😊