Should You Take Out a Loan to Pay Your Tax Debt?

Owing money to the IRS is stressful. If you get hit with a large tax bill you can’t afford to pay all at once, you may be tempted to take out a loan to cover it. Personal loans, home equity loans, and credit cards are some options.

But is borrowing to pay the IRS ever a smart financial move? Or will it just create more problems down the road? Here’s what to consider before taking out a loan for taxes.

The Risks of Using Debt for Taxes

Tax debt is not like other types of debt. The IRS has powerful collection abilities and can seize your assets or garnish your wages if you don’t pay. Still, borrowing to pay taxes can be risky:

• You may be borrowing at a higher interest rate. Unless you have stellar credit, personal loan rates are generally higher than the IRS charges.

• You’ll have another monthly bill The loan payment is added on top of your other obligations and may be difficult to manage,

• You could damage your credit. Defaulting on a loan hurts your credit score, which may limit your options for affordable IRS payment plans.

• The IRS debt remains Even if you pay the IRS with a loan, future back taxes and penalties will continue to accrue until the underlying issue is resolved

• Other debts aren’t addressed. Personal loans provide temporary relief rather than dealing with systemic financial issues.

Unless you take meaningful steps to fix the root problem, borrowing for taxes can start you down a slippery slope.

When Loans May Make Sense for Tax Debt

However, there are some situations where it may be appropriate to use debt to pay off the IRS:

• You need a short-term emergency loan. If you’re hit with an unexpected tax bill and need funds immediately to avoid aggressive collections, a loan may be your only viable option. Just be sure you can repay it quickly.

• You can get a lower interest rate. An affordable loan with a lower rate than IRS penalties provides savings on interest. Consolidating high-rate debts under one loan can help with this.

• You can qualify for a settlement. Borrowing a lump sum to settle tax debt for less than you owe stops penalties and seizures quickly. Make sure the settlement offer is in writing first.

• You need a loan while building savings. If you have a plan to save up for paying the IRS but need time, a low-rate loan can bridge the gap and avoid collections.

• The debt prevents you from borrowing. Clearing IRS debt off your record may allow you to qualify for financing needed for things like a mortgage or expanding a business.

The key is having a solid repayment plan for the loan and addressing the root causes of your tax issues.

Tax Debt Relief Options to Consider First

Before turning to a loan, explore these alternative options to address tax debt:

• Payment plans – The IRS offers payment plans that let you pay over 6-72 months. Installment agreements have lower monthly costs without a loan.

• Penalty relief – You may qualify for penalty abatement if you have a reasonable cause. This reduces what you owe.

• Settle for less – An Offer in Compromise allows you to settle tax debt for less than the full amount in some cases.

• Hire a tax pro – An Enrolled Agent can help get your taxes back on track, resolve issues with the IRS, and prevent future debts from accruing.

• Change withholdings – Update your Form W-4 with your employer to have more tax withheld from your paycheck and avoid another tax bill.

Most importantly, address the underlying reasons you owe taxes, like underpaying estimated taxes or claiming excessive deductions. Doing so will help avoid repeat tax debts.

Compare Loan Options for Paying the IRS

If you determine a loan is your best or only option, here are some options to consider:

Personal Loans

Unsecured personal loans can provide funds relatively quickly without collateral. Lenders deposit the money directly into your bank account to use for any purpose.

Pros

• Fast funding
• Fixed payments
• Simple application

Cons

• High rates for poor credit
• Large loans difficult to qualify for
• Origination fees

Home Equity Loans

Home equity loans tap your home equity by using your house as collateral. Rates are often lower than other options.

Pros

• Lower rates than personal loans
• Interest may be tax deductible

Cons

• Risk losing your home
• Closing costs and fees
• Need substantial home equity

401(k) Loans

Borrowing against your 401(k) avoids credit checks and offers low interest paid to yourself. However, it risks your retirement funds.

Pros

• Low interest (paid to yourself)
• No credit check

Cons

• Reduces retirement savings
• Possible early withdrawal penalties
• Potential double taxation

Credit Cards

Balance transfer or low introductory rate credit cards allow you to pay over time. However, rates spike after the intro period.

Pros

• 0% intro rate on some cards
• Can pay over time

Cons

• Very high ongoing rates
• Compound interest builds
• Credit limit may be insufficient

Payday Loans

Payday loans provide fast cash without checking your credit. But they carry extremely high rates and pile on more debt.

Pros

• Fast funding
• No credit check

Cons

• Sky-high interest
• Difficult to repay quickly
• Predatory lending practices

Questions to Ask Before Borrowing for Taxes

Before taking out a loan to pay the IRS, ask yourself:

• What caused me to fall behind on my taxes?
• Have I explored options like payment plans and penalty relief?
• Can I cut expenses elsewhere to pay the IRS over time?
• Will borrowing make it harder to stay current on future tax bills?
• Can I realistically manage another monthly loan payment?
• Will I likely need to borrow again for future tax debts?

Being honest about what led to your tax debt in the first place and whether a loan truly makes sense for your situation will help you make a wise financial decision.

The Bottom Line

Using debt to pay off tax obligations to the IRS is usually inadvisable, since it trades one debt for another. But in certain circumstances, an affordable loan at a low interest rate can provide much-needed relief. Just make sure you address the root causes of your tax debt and realistically assess whether taking on a loan payment is sustainable for your budget in the long run. With the right plan, borrowing strategically can resolve IRS issues and allow you to pay your taxes on time going forward.