Should You Pay Your Taxes With a Credit Card?

While the majority of American will expect a tax refund this year, there are still a sizable fraction of us who will have to scrounge up their savings to pay Uncle Sam what they owe.

And while some are vaguely aware that there are ways to pay taxes with their credit cards, few really understand the benefits and drawbacks of these options.

Here are the basics.

How to pay taxes with a credit card

The IRS is happy to receive payment in the form of a check, but they do not directly accept credit cards. Instead, they have authorized a handful of private companies to accept payment on their behalf. And while this service is convenient, it comes at a cost. Authorized processors charge a fee of between 1.88% and 2.35% of the amount remitted to the IRS. In addition, some state and local governments will also accept taxes paid with a credit card.

To choose from an authorized payment processor, visit the IRS credit card payment site.

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Paying taxes with a credit card versus a debit card

In addition to credit cards, taxpayers can also use their debit cards to remit payment to the IRS through the same authorized payment processors. And rather than being charged a percentage of their payment, payments using a debit card only incur a flat fee of about $2- $3 per payment. Therefore, taxpayers who are only using a payment processor for convenience alone will want to use a debit card instead of a credit card, so long as their payment is above approximately $100.

When it makes sense to use a credit card

With a credit card fee of at least 1.88%, most taxpayers will save money by simply mailing a check to the IRS. But there are some rare situations where payments using a credit card can make sense. First, those who have a card with a 0% APR promotional financing offer can avoid interest for as long as 18 months. This may be the best option for cardholders who are unable to pay their tax bill immediately.

Also, there are very few credit cards that offer rewards greater than the fees the processors charge, but they do exist. For example, the Capital One Venture Rewards card offers double miles for each dollar spent, and each mile is worth one cent as a statement credit towards any travel related expense. So by paying a 1.88% credit card fee, cardholders still earn a small, .12% reward on their tax bill. For example, a $2,000 tax payment would result in a net gain of $2.40 worth of rewards.

And finally, paying taxes with a credit card can be an easy way to meet the minimum spending requirements necessary to receive a credit card’s sign-up bonus . For instance, new applicants for the Starwood Preferred Guest card from American Express earn 10,000 points after their first purchase, and another 15,000 points after spending $5,000 within six months. If cardholders are unable to spend $5,000 in that time, incurring the credit card fee to pay taxes might be worthwhile as the additional 15,000 points that can be worth hundreds of dollars in rewards. Even then, these strategies only makes sense when cardholders avoid interest by paying their statement balance in full.

Why it’s a bad idea to use a credit card

Unless cardholders are using a 0% APR promotional financing offer, it makes no sense to use a credit card as a means of financing a tax payment. This is because the IRS offers its own financing options with lower interest rates. For instance, their current rate is 3%, although it can be adjusted each quarter. This is far below the standard interest rates of any credit card, especially when the credit card processing fee is considered. And while these installment plans do have a setup fees, they still offer more savings for most cardholders compared to credit card fees and interest.

By understanding the process of paying taxes with a credit card, taxpayers can make the best decision when it comes time to fulfill this essential obligation.

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Retirement Savings Credit Doubles Payoff

Contributors to retirement plans already know the long-term tax advantages of an individual retirement account or 401(k). Taxes are deferred, and in some cases never collected, on money put away for the golden years.

Now a tax credit will let some savers reap the rewards of their retirement thrift early.

The retirement savings contributions credit, also called the saver's credit, appears on Form 1040 and Form 1040A tax returns as a way to reward lower-wage earners who sock away retirement money.

Because the tax break is a credit instead of a deduction, it's a better deal. Tax deductions reduce taxable income, but credits come into play after you calculate how much tax you owe, and they reduce your Internal Revenue Service bill dollar for dollar. For example, if you owe $500 and you are eligible for a $250 credit, the check you have to write to Uncle Sam is cut in half.

Income limits

A filer eligible for the saver's credit could shave as much as $1,000 off his or her tax bill. The actual credit amount depends on your income, filing status and just how much you put into retirement plans.

Basically, the lower your income, the bigger your credit. The income limits that determine how large a credit you can claim are adjusted annually to keep pace with inflation. The precise credit percentages for 2012 filings are found in the table below.

As the table shows, the maximum available credit is 50 percent of contributions for filers in the lower end of the earnings ranges. There is, however, a limit on the retirement plan contribution amount you can use to figure the tax break.

Although tax law allowed you to put up to $5,000 in 2012 ($6,000 if you're age 50 or older) in your IRA, only $2,000 of that will count in figuring the saver's credit. That makes it worth at most $1,000 for single taxpayers. Of course, if you're married and you and your spouse put away at least $2,000 toward retirement, your joint return would reflect a $2,000 credit.

Which contributions count?

Contributions to traditional and Roth IRAs as well as to employer-sponsored 401(k) plans count toward computing the credit. So does money you put into a savings incentive match plan for employees, or Simple, plan; a 403(b) program; a governmental 457 plan; or a salary reduction simplified employee pension, or SEP. You can only count the money you put in your workplace account, not any matching amounts your company contributed.

The credit is based on your total contributions to all your eligible retirement accounts, not for contributions to each. So if you put $2,000 into a Roth and another $2,000 into your 401(k) at work, you still can only calculate your credit on the allowable maximum of $2,000.

Enter all your retirement saving amounts on Form 8880, Credit for Qualified Retirement Savings Contributions, and complete the form to arrive at your exact credit rate and amount. Once you get the dollar amount, transfer it to line 50 of your 1040 or line 32 if you file the 1040A. The credit isn't available for 1040EZ filers, so you might want to consider changing your choice of returns if you've been putting away retirement cash.

If your IRA contribution is to a traditional account, you may be able to get a double tax break. In addition to the saver's credit, look into whether you're eligible to deduct your IRA contributions on the front page of your 1040 or 1040A. This tax break is one of several adjustments to income that are available to all taxpayers, regardless of whether they are itemizing or taking the standard deduction, and the IRS says you can claim the retirement savings credit and deduction for your IRA contributions.

The credit also is attractive to workers who are eligible to participate in a 401(k) plan but who earn just more than one of the saver's credit income limits. By signing up for a company-sponsored account, such workers could get under the earnings cap while simultaneously boosting the potential credit amount.

Take, for example, a married employee who is the sole earner in her family and who reports adjusted gross income of $35,000 on her joint tax return. She's already eligible for a partial credit, but if she contributes $2,000 to her 401(k), she will knock her income down enough to take the maximum credit.

Some other restrictions apply

In addition to the income limits, there are a few other restrictions on who can claim the saver's credit. A taxpayer who was younger than 18 last year, a full-time student or claimed as a dependent on another's tax return can't take the retirement savings break.

The saver's credit is also what the IRS calls nonrefundable. That means you can use it to reduce your tax bill to zero, but you can't take advantage of any excess credit amount to get a refund. So if you owe no taxes, the credit is of no use to you.

Still, even if you can't take full advantage of the credit, it's not too shabby of a break when you take into account the additional tax savings you get by contributing to a retirement account in the first place.

Just remember, the key to this credit is participation in retirement accounts. If you haven't opened a retirement account yet, or have one but haven't contributed for the 2012 tax year, you have until the April tax-filing deadline to open one and put in money. The deadline is the same for either a Roth or traditional IRA.

As for your 401(k), you're locked into your credit for the 2012 tax year based on the contributions you made last year. Make sure the W-2 you got from your company reflects the correct amount of all your pension contributions so you can get the maximum credit.

If you're not yet participating in your company plan, you can improve your future saver's credit potential by signing up as soon as you're eligible. Then contribute as much as you can afford without doing major cash-flow damage to your paycheck. It could pay off at tax-filing time as well as when you retire.

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