How Does Owing Taxes Work and What Happens Next?

Owing taxes can be stressful, especially if you’re unsure of what to expect. When you have a balance due with the IRS or your state tax agency, understanding the process can help you manage the situation effectively. Ignoring the issue can lead to additional costs and enforcement actions.

Tax agencies follow a structured process when handling unpaid taxes. Knowing how interest, penalties, payment options, and collection efforts work will help you navigate the situation.

Why a Tax Bill Occurs

A tax bill arises when the amount owed exceeds what was paid throughout the year. This often happens due to insufficient paycheck withholding, underpayment of estimated taxes, or unreported income. Independent contractors who don’t make quarterly estimated tax payments may face a large balance when filing. Employees who claim too many allowances on their W-4 may also find they haven’t had enough withheld.

Changes in tax laws or personal circumstances can create an unexpected balance. If tax credits or deductions are reduced or eliminated, the final liability may be higher than anticipated. The expiration of pandemic-related tax relief measures, for instance, has surprised some taxpayers. Life events like marriage, divorce, or the birth of a child can also affect filing status and deductions.

Investment income is another factor. Capital gains from selling stocks, rental income, or dividends typically don’t have taxes withheld at the time of payment. If estimated payments aren’t made, taxpayers may face a significant balance.

Interest and Penalties

Unpaid taxes grow over time due to interest and penalties. Interest starts accruing from the tax return’s due date, even if an extension was filed. The IRS calculates interest daily based on the federal short-term rate plus 3%, adjusting it quarterly. If the federal short-term rate is 5%, the total interest rate on unpaid taxes would be 8% annually. Since interest compounds daily, even a small balance can grow significantly.

Penalties further increase the amount owed. The failure-to-pay penalty is 0.5% of the unpaid tax per month, up to 25% of the total balance. If a taxpayer also fails to file their return on time, a failure-to-file penalty applies—5% per month, up to a maximum of 25%. If both penalties apply in the same month, the failure-to-file penalty is reduced by the failure-to-pay penalty, keeping the combined maximum at 5% per month.

More severe penalties apply in certain cases. If the IRS determines that underpayment resulted from negligence or intentional disregard of tax rules, a 20% accuracy-related penalty may be added. In cases of fraud, the penalty can be as high as 75% of the underpaid tax. These penalties are separate from interest and continue accumulating until the balance is resolved.

Receiving Payment Notices

Once a tax balance remains unpaid, the IRS or state tax agency sends a series of notices. The first notice, often a CP14 from the IRS, outlines the amount due, including the original tax liability, interest, and penalties. It serves as a formal request for payment and provides a deadline to avoid further consequences.

If the balance remains unpaid, additional notices follow. A CP501 serves as a reminder, while a CP503 warns that the IRS has not received a response and may take collection actions. If ignored, a CP504 notice is issued, informing the taxpayer that the IRS may levy state tax refunds or other assets. These notices indicate that the collection process is escalating.

State tax agencies follow similar procedures, though specific notices vary by jurisdiction. California’s Franchise Tax Board (FTB) sends a Notice of Tax Due, followed by a Demand for Payment if the balance remains unresolved. New York’s Department of Taxation and Finance issues a Consolidated Statement of Tax Liabilities, detailing the total amount owed across multiple tax periods. These notices often provide instructions on disputing discrepancies, requesting payment extensions, or exploring resolution options before enforcement actions begin.

Payment Arrangements

If full payment isn’t immediately possible, structured repayment options allow taxpayers to settle their obligations over time. The IRS and most state tax agencies offer installment agreements, breaking the total amount into manageable monthly payments. Eligibility depends on the balance, prior compliance history, and ability to pay. For individuals owing $50,000 or less, a streamlined installment agreement can often be set up online without submitting financial documentation, provided the debt is repaid within 72 months. Larger balances require a more detailed review, including disclosure of income, assets, and expenses via Form 433-A or 433-F.

Choosing a payment plan involves balancing affordability with the financial impact of prolonged repayment. While installment agreements prevent aggressive collection actions, interest and penalties continue accruing until the balance is fully paid. Taxpayers who can make larger payments may reduce overall costs. Those who can pay within 180 days may qualify for a short-term payment plan, avoiding formal installment agreement fees, which range from $31 for direct debit arrangements to $130 for non-direct debit options.

Possible Enforcement Actions

If a tax balance remains unpaid despite multiple notices, tax agencies escalate collection efforts. The IRS and state tax authorities have broad enforcement powers, including liens on property and direct asset seizures. The severity of these actions depends on the amount owed, the length of delinquency, and the taxpayer’s responsiveness to prior notices.

Tax Liens

A federal tax lien is a legal claim against a taxpayer’s property, including real estate, personal assets, and financial accounts. The IRS files a Notice of Federal Tax Lien with public records, alerting creditors that the government has a priority claim over the taxpayer’s assets. This can make it difficult to secure loans, refinance a mortgage, or sell property. While a lien does not result in immediate asset seizure, it remains in place until the debt is fully satisfied or the IRS withdraws it under specific conditions. Under the Fresh Start Program, some taxpayers can request lien withdrawal if they enter a direct debit installment agreement and owe $25,000 or less.

Wage Garnishments and Bank Levies

If a tax debt remains unresolved, the IRS can issue a wage garnishment, directing an employer to withhold a portion of the taxpayer’s paycheck until the balance is paid. Unlike typical wage garnishments, which are subject to state limits, IRS levies are more aggressive, often leaving individuals with only a minimal amount for living expenses. Additionally, the IRS can issue a bank levy, freezing and seizing funds from a taxpayer’s bank account. Once a levy is placed, the bank must hold the funds for 21 days before remitting them to the IRS, allowing time for the taxpayer to negotiate a resolution.

Seizure of Assets and Passport Restrictions

In extreme cases, the IRS can seize physical assets, including homes, vehicles, and business property, to satisfy unpaid taxes. While asset seizures are less common, they are used when taxpayers repeatedly ignore collection efforts. Additionally, under the Fixing America’s Surface Transportation (FAST) Act, individuals with tax debts exceeding $62,000 (adjusted annually for inflation) may have their passports revoked or denied renewal. The IRS certifies seriously delinquent tax debts to the State Department, which can restrict international travel until the taxpayer resolves the balance through payment or an approved installment agreement.