Can You Pay Taxes with a Credit Card?
The short answer is yes, but a better question is should you? The IRS generally charges a convenience fee of around 2% depending on who you select as the credit card processor, although debit cards are only assessed a flat fee of $2 or $3. A digital wallet is a third option. The fee associated with a digital wallet will be calculated based on what kind of card is linked to the wallet.
Convenience fees for larger payments can add up quickly. For example, if you owe the IRS $5,000 and have a convenience fee of 2%, you will pay an additional $100.
Convenience Fees by Processor
Debit Card - $2.65 flat fee
Credit Card – 1.98% fee with a minimum of $2.69
Debit Card - $2.59 flat fee
Credit Card – 1.87% fee with a minimum of $2.59
Debit Card- $2.25 flat fee under $1000.00; $3.95 flat fee over $1000.00
Credit Card – 2.00% fee with a minimum of $2.50
There is risk associated with paying a debt with a credit card. By paying with credit you are essentially trading one debt for another. However, for many people paying with a credit card is a viable solution. An unexpected tax liability can throw a wrench into an individual's budget. Although unexpected, the taxes still need to be paid and paying with a credit card can be necessary.
There are both pros and cons associating with paying your tax liability with a credit card. Ultimately, the right information can help you decide if this option is right for you.
Counting the benefits of paying taxes with credit cards
Using a credit card to pay your taxes may be a good idea, especially if your credit card helps to save you money. Here are some additional reasons you may want to consider.
Using a cashback card
Using a credit card that offers a cash back will help lessen the impact of the convenience fee. Many credit cards pay a 1-2% cashback bonus when using the card. Some cards offer an initial signup bonus once you charge a certain amount within the first few months of opening the card. Some offer a cashback bonus that can be as high as a few hundreds dollars. Be advised, however, that some cashback rewards can be taxed if substantial.
In short, if the cashback bonus you receive outstrips the penalty of paying with credit, it is wise to consider.
As an example: your new card offers a cashback bonus of $150 when you spend $3,000. If your tax bill is also $3,000, and you use your card to pay your taxes, even with a convenience fee of 2.5% ($75), your net cashback will be $75.
Earning bonus rewards on credit cards
Many credit cards offer miles or other rewards for using them. A point-earning card allows members to earn membership reward points per every dollar spent. These points can be spent at designated stores or simply redeemed for airline travel, hotel stays, car rentals, and gift cards.
Charging your taxes to a rewards card may earn a substantial number of rewards points. Always check the cardholder agreement first, because not all reward programs allow rewards for payments to the IRS. Some cards place a limit on the number of redeemable rewards as well.
Using Rewards Debit Cards
Although not as common as credit cards, there are some debit cards that offer their users similar rewards. Many of these cards offer no minimum balance and no monthly maintenance fee, but still earn points and miles. PayPal Business Debit card, for example, offers 1% cashback for online or over the phone purchases and any purchases that require a signature. Another benefit of the Paypal Business Debit card is that there is no limit on rewards and no annual fee. Using a rewards debit card, in fact, allows you to use the money you already have and still get similar rewards of a credit card without incurring additional debt.
Churning Credit Cards
Credit card churning is opening a credit card that offers a sign-up bonus, using the card long enough to get the bonus, and then closing the account. This approach can be used to help cash out on rewards if utilized the right way. To help clear a tax debt, a user could open a credit card that offers a sizable signup bonus, quickly pay the tax debt or a portion of the debt, and reap the sign-up bonus. Once that user receives the sign-up bonus, she can transfer the balance to another new card that offers a sign-up bonus, then collect a new bonus.
For this to be lucrative, the balance would need to be transferred and the card closed before the introductory period is up. This usually will keep you from owing interest or annual fees. This type of churning can go on as long as you are approved for new credit cards.
If churning is an option for you, a good tip is to apply for a couple of cards in one day, then wait a few months to apply for more. This way the impact on your FICO credit score is minimized since only one hard pull of your credit score registers per day. Applying for or accepting new credit cards has little to do with credit scores since only 10% of the FICO is based on new accounts. Length of history, on-time payments, and credit utilization (essentially your debt to credit limit ratio) comprise the majority of the score. If you keep balances low, with on-time payments and reap enough valuable rewards, churning should not be an issue.
Take advantage of zero interest rates
Many credit cards offer competitive rates and an introductory, zero-interest period of up to 6-12 months. This allows you to pay your tax debt interest-free. One thing to keep in mind is that the IRS interest rate will never fall below 3%, so finding a card with 0% is a viable solution. If you can pay your credit card debt within the interest-free time frame, charging your taxes may prove to be a wise decision. It may be possible to extend the zero-interest period for additional time with a balance transfer offer. Of course, you must consider the usage fee (maybe 2%) you will incur to take advantage of the zero interest rate. However, avoid using this technique too often, since it can lower your credit score.
Deduct convenience fees
If you itemize your taxes, the convenience fee qualifies as a miscellaneous itemized deduction. To benefit from this deduction, your total miscellaneous itemized deductions need to exceed 2% of your adjusted gross income (AGI). For example, if your AGI is $100,000, the convenience fee plus other miscellaneous deductions would need to exceed $2,000 to receive any tax benefit.
For business owners, the convenience fee qualifies as a deductible business expense only if the business is incorporated. Unincorporated businesses would not be able to deduct this fee as a business expense.
Minimizing IRS penalties
If you don’t have the funds to pay your taxes by the due date of the return, the IRS gives you the option of entering into an installment agreement to pay the balance due. The installment agreement requires an initial fee that ranges anywhere from $43-$105. (More on this later.) In some cases, the initial fee could be higher than the fee of charging your tax bill to a credit card.
If you neglect or are unable to pay your entire tax balance when due, the IRS will charge late payment penalties until the taxes are fully paid. Penalties are calculated every month, as a percentage (0.5%) of your remaining unpaid balance. Filing a late tax return should be avoided at all costs, as a late return results in even higher penalties each month (5%). Each of these penalties can reach up to 25% of your original unpaid balance, or a total of 50%. In addition, the IRS charges interest, currently at the rate of 4%.
In conclusion, paying off your tax bill with a credit card will assist in avoiding some or all of these penalty and interest charges, and can amount to substantial savings if used correctly.
For example, if setting up monthly payments with the IRS costs you $105, but your total tax bill is $3,000, you’ll save money by paying with your credit card provided you do not have to pay interest on the balance. That’s because 2% convenience fee on $3,000 ($60) would be less than the $105 you would pay by setting up an IRS installment agreement. Note that setting up the $105 installment fee does not eliminate additional penalties by the IRS, so in practice paying this amount of money off with a credit card is even more likely to save you money.
Weighing the disadvantages of credit card debt
Paying your taxes using a credit card can leave you further in debt if you are not careful. Here are a few reasons to consider other payment options.
Increasing taxable income
One thing to take into consideration when using credit card rewards is that the rewards may be treated as taxable income. The fine line is drawn by what type or reward and how you receive the bonus. Most generally, rewards are considered a discount if the credit card transaction was treated as a post-purchase vs. a pre-purchase. Most large sign-up bonuses are counted as taxable income.
Keep in mind, rebates on business purchases charged with a business credit card reduce the total amount of deductible expenses and could increase your tax burden. If these are treated as income, you will receive a 1099-Misc tax form reporting the amount of the reward. Since anything given as a reward (that is not attached to the credit card) can be considered taxable income, it is best to ask a tax Expert how this may affect your specific situation.
High debt-to-credit ratio
High credit card debt can negatively influence your credit score. Credit bureaus partially base your score on how much debt you have versus how much credit is available to you. This is called credit utilization. Generally speaking, the lower the ratio, the better. As an illustration, if you charge your card $2,500 every month but have an accumulated $25,000 credit limit across all your cards, you utilize about 10% of your total credit.
Charging a large tax bill to your credit card could potentially lower your credit score if you are not careful. If you have several high-limit cards, and a debt to credit ratio that is below 25%, you probably will not see any drop in your credit score.
Lenders may look at accounts with a high balance or high utilization as a risk, as it signals that the debtor is “living on credit” or may be less likely to pay back the debt.
Adding amounts to a credit card for a tax liability will create an additional monthly obligation. What you may be doing is substituting one debt for another, where the debt you’re assuming is likely to have a higher downside than before. Additional credit card payments can make it more difficult to meet your current tax year responsibilities. In the end, it is better to address your tax obligations by setting money aside during the year than to be overwhelmed with a large liability come tax time.
Charting an alternate course
If you are still unsure whether using a credit card to pay your taxes is a good idea, you may consider opening a HELOC.
Home equity line of credit (HELOC)
A HELOC works the same way as a credit card but uses the equity in your home as collateral instead. In most cases, HELOCs carry lower interest rates than credit cards.
However, it can take some time to establish a new home equity line of credit, as additional documentation is often required by the lender. Not being able to meet this obligation in the future may put your homeownership at risk.
The best way to decide which option is right for you is to compare the different alternatives. For example, assume your tax bill is $3,500 and you will pay it off in 12 months. You can set up an IRS installment agreement, pay with a card that charges an annual percentage rate (APR) of 15% or pay with a zero-interest card. For this example we will assume you will pay a convenience fee of 2% for using a credit card. Here is how it will break down:
Installment plan – Setup fee: $52 (or $107 if using direct debit payments). Interest and penalties: $133. Total cost: $185
15% APR – Convenience fee: $70. Interest and penalties: $277. Total cost: $347
0% APR – Convenience fee: $70.
Although this is just a simple example there are times where paying with a credit card is the best option, just as there are times when paying with a credit card is more expensive. The bottom line is it’s never smart to pay non-filing and non-payment penalties, as well as interest, to the IRS if you can afford not to.
Using credit cards wisely
If you do use a credit card to pay your taxes, be smart about it. If you can afford to pay off your taxes right away but choose to use credit because a rewards offer is relatively high, it’s probably worth it. On the other hand, if you can’t afford to pay your taxes and want to offload the debt onto another source, it’s probably best not to use a credit card. Instead, consider the IRS’s installment plan and remember to file on time.
Ultimately, if you do decide to charge a tax bill on your credit card, use these tips to help reduce your debt faster:
Pay as much of the debt off as possible – preferably more than the minimum payment – especially in the beginning. Many credit card issuers calculate interest on your average balance. Paying extra can amount to savings.
Make payments on time, every time. Once an account is in default, credit card issuers charge late fees and increase the interest rate on the card.
Consider setting up minimum credit card payments for all of your credit card accounts. That way, if for some reason you don’t make your regular payment on time, you won’t run into all the negative things that can happen when you miss a payment on your credit card.
More important than the possible extra charges, increase in interest rate, or lowering of your credit line is the possible negative effect on your credit score that comes with mismanagement. Consistently making payments on time is the single best way to have a positive effect on your credit report. So setting up the automatic minimum payments acts like a small insurance policy against ever having a late payment haunt you and your credit score for quite some time.
If you need help evaluating your options or reducing the next year’s tax liability, ask a tax Expert for customized answers at a reasonable price from the comfort of your home.