Ask DWM: Should I pay my (expected) income tax bill with a credit card?

Last week, one of our favorite client couples asked this question.?They knew they had a bill coming up for taxes. We had reviewed their estimated tax liability a number of times last year with them after they had made a nice capital gain on the sale of a piece of real estate they owned. We made sure that they had made sufficient tax estimates throughout the year so there was no penalty for underpayment and now the payment was coming near. Further, they both love to use their credit cards responsibly, paying off the balance each month and not exceeding 30% of the credit limit. They like the points and some of the programs that new and existing cards offer and thought it might make sense to use credit cards to pay the bill.

Here was our response:

Yes, it is possible to pay taxes with your credit card and it could result in more cash in your pocket at the end of the day. The federal government doesn’t directly accept payments through credit cards, but rather uses authorized payment processors such as Pay1040, PayUSAtax, or OfficialPayments. Most states, such as South Carolina and Illinois, also allow the use of credit cards to pay your income tax bill, but not all. Before we go into any further detail, we must first address the primary consideration when determining whether it is beneficial to use a credit card: processing fees. Processing fees are likely the reason you are not too familiar with the idea of using a card; on a large bill, they can be significant. Processing fees made on regular federal tax payments range from 1.82% to 1.98% and fees paid when you e-file your federal 1040 using online software can range from 2.49% to 2.95%. So, make sure you reference this link to ensure you’re paying the lowest rate. Processing fees vary for each state. Unfortunately, these fees automatically disqualify a portion of Americans who do not own a credit card with a good rewards program. However, there are many that do qualify to benefit.

As we all know, there are benefits to using a credit card. The most well-known is cash back. Cash back is a rewards program that returns a small percentage of the amount spent back to the cardholder. Cash back rates normally range from 1% to 5%, but there are limitations. Often, to get cash back at a higher rate, the spending must fall into a certain category, such as groceries or airfare. Additionally, many cards have a monthly or annual limit on the cash back they reward. If you get 4% cash back, for example, you may be limited in rewards to $100/month. So, before you jump at the opportunity to take advantage of the arbitrage between your cash back rate and the processing rate, make sure you can realize the full benefit of the rate.

Another benefit to consider is bonuses offered on credit cards based on surpassing a certain spending threshold, often more than $3,000. This benefit is usually offered on new cards and has a time limit, such as 3 months, to reach the threshold. There may be opportunities to realize the most benefit from paying taxes with credit cards if this opportunity is offered to you. Nonetheless, careful consideration and analysis are needed before making a decision. There is a lot of fine print when it comes to credit cards. Perhaps you might not receive the benefit as a cash reward. Perhaps the spending threshold only applies to specific categories such as entertainment. This strategy is not beneficial for everyone. If you are considering this approach, we ask that you reach out to a trusted advisor to run an analysis. Ultimately, this strategy only works if the rewards outweigh the processing fee, and these rewards are sometimes different than they may seem at face value.

While we’re on the topic of credit cards and taxation, we believe it’s valuable to review any other implications that may arise from credit card usage. Through credit card cash back programs, you are being paid in the form of rewards for your spending, but is this taxable income? Fortunately, it is not. The IRS treats cash back and bonus programs as a rebate on your spending, not as income, meaning that using a credit card to pay your tax bill and earning rewards would not increase your income subject to taxation. Another concern may be how paying your tax bill affects your credit score. The effect is the same as that of credit usage for any other service or good. If you are unable to make timely payments or if your credit utilization goes above 30%, you may see a decrease in your credit score. However, late payments have a much more significant effect on your score than short-term credit utilization (if your short-term utilization goes above 30%, there would be no effect, but on a long-term basis, you may see a small decrease in your score).? Lastly, we’ve been asked the question, “Can I deduct the interest I pay on credit cards on my tax return?” The answer is no; the only interest deductible on your tax return is interest paid on your mortgage for a qualified primary residence and certain qualified investment interest.

In summary, while using a credit card to pay income taxes presents potential benefits, such as earning rewards or cash back, it is a strategy that requires meticulous consideration due to the processing fee involved, a minimum of 1.82%. For this program to make sense, you must compare the processing fee on your tax payment against the credit card rewards. If your rewards exceed the minimum 1.82% cost on the federal tax bill and the respective state processing fee, then this program is for you. In the end, this strategy demands a careful analysis to ensure that the financial benefits justify the costs. If you’re considering paying with a card, and would like a second pair of eyes, reach out to your trusted advisor, DWM.

https://dwmgmt.com/