Introduction

When you owe the IRS, the base tax balance is only the starting point. Two common extra costs—penalties and interest—can double or more the amount you actually pay if you don’t choose the right path. In my 15 years as a financial educator and CPA I’ve helped clients move from surprise collections to manageable solutions simply by understanding how penalties and interest behave under each IRS program.

This guide explains the practical differences among the main IRS payment options, how each one affects penalties and interest, and what to do first to limit added costs. Where useful, I link to IRS guidance and related hands-on articles on FinHelp.

Key facts you should know (short)

  • Interest accrues on unpaid taxes from the original due date until the balance is paid in full; it compounds daily and is set quarterly using the federal short-term rate plus 3 percentage points (IRC §6621). See IRS interest rates for updates. (IRS Interest Rates).
  • The Failure-to-File penalty is generally 5% of the unpaid tax per month (up to 25%); the Failure-to-Pay penalty is generally 0.5% per month (up to 25%). The IRS explains penalties and relief options on its penalties page. (IRS Penalties).
  • Entering a payment plan usually stops aggressive collection steps (for example, the IRS typically will not levy wages while an active installment agreement is in good standing), but it does not automatically stop interest from accruing.

How the IRS calculates interest and penalties (brief method)

  • Interest: Calculated on the unpaid balance starting the day after the tax due date; compounded daily; rate changes quarterly. (IRS: “Interest Rates”.)
  • Failure-to-File (FTF): Higher penalty, charged when you file late—5% per month on unpaid tax, up to 25%.
  • Failure-to-Pay (FTP): Charged when you pay late—0.5% per month on unpaid tax, up to 25%.
  • If both penalties apply in the same month, the FTF penalty is reduced by the amount of the FTP penalty for that month; but the practical takeaway is that filing on time is the cheapest fast step because FTF penalties grow faster.

Installment Agreements (Short- and Long-term)

What it is: An Installment Agreement (IA) lets you pay an existing tax balance over time. The IRS offers many IA types—short-term (usually 120 days or less) and long-term (monthly payments).

How penalties and interest behave:

  • Interest continues to accrue on the unpaid balance until the tax is paid in full. Interest is not suspended by an IA.
  • Failure-to-Pay penalties generally continue to apply while the tax remains unpaid, although entering into a formal IA stops collection actions (levies) when the agreement is in good standing.
  • In practice: setting up a manageable monthly payment (and keeping it current) prevents additional enforcement and can limit total penalty accrual by shortening the unpaid period.

Practical tips:

Partial-Payment Installment Agreements (PPIAs)

What it is: A PPIA acknowledges the IRS may collect only a portion of the debt over time based on your current ability to pay.

How penalties and interest behave:

  • Interest continues to accrue on the unpaid balances not covered by the payment plan.
  • Penalties continue unless and until the IRS accepts another form of relief.

Offer in Compromise (OIC)

What it is: An OIC is a negotiated settlement where the IRS accepts less than the full tax debt when full collection would create financial hardship and the offer reflects the taxpayer’s reasonable collection potential.

How penalties and interest behave:

  • While an OIC is pending, penalties and interest generally continue to accrue on the original balance.
  • If the IRS accepts your OIC and you pay the agreed amount, the remaining tax liability is discharged; no further interest or penalties accrue on the settled amounts after the offer is accepted and satisfied. (See IRS Offer in Compromise guidance: https://www.irs.gov/businesses/small-businesses-self-employed/offer-in-compromise.)

Practical tips:

Currently Not Collectible (CNC)

What it is: CNC status is a temporary suspension of IRS collection activity when you can show you cannot pay both living expenses and the tax debt.

How penalties and interest behave:

  • The IRS will generally suspend collection actions (levies, garnishments) while under CNC status.
  • Interest and most penalties continue to accrue on the unpaid balance even while your account is classified CNC. CNC is a collection pause rather than a forgiveness of interest or penalties.
  • The IRS can return to active collection if your financial situation improves.

When CNC helps: CNC is useful if you need short-term relief to get through unemployment, hospitalization, or other severe hardship, but it is not a long-term solution to stop interest growth.

Penalty Abatement and Relief Options

The IRS provides limited relief options that can reduce or remove penalties (but not usually interest):

  • First-Time Penalty Abatement (FTA): One-time relief for qualifying taxpayers with a clean recent compliance history. (See IRS Penalty Relief page.)
  • Reasonable cause abatement: If you can show specific, verifiable reasons (serious illness, natural disaster, etc.) prevented timely payment or filing.
  • Administrative waiver or correction: Rarely used, but available in special cases.

Note: Interest is usually statutory and harder to remove; abatement typically applies to penalties, not interest. If penalty abatement is granted, the IRS may recalculate amounts owed which can lower total cost.

Real-world examples (illustrative)

  • Example A — Installment Agreement: A taxpayer with $12,000 due sets up a 36-month IA and pays $350 monthly. Interest continues to accrue until the balance is paid, but by reducing principal consistently the total interest and FTP penalty paid over time is far less than if the account entered levy and collection.

  • Example B — Offer in Compromise: A self-employed taxpayer with $40,000 in tax debt submits a carefully documented OIC showing minimal disposable income. While the OIC is pending, interest grows, so a strong, early submission and reasonable payment while the OIC is considered can reduce total costs.

Steps to reduce penalties and interest (action plan)

  1. File on time even if you can’t pay. Filing reduces or avoids the Failure-to-File penalty (5% per month) and preserves eligibility for relief.
  2. Explore an Installment Agreement to stop most collection actions and set a defined payoff schedule.
  3. Consider an Offer in Compromise only if your financial projection shows you cannot ever pay the full balance.
  4. If you have a qualifying hardship, ask about CNC to stop collection while stabilizing your finances.
  5. Request penalty abatement if you have reasonable cause or qualify for first-time relief — do this promptly with documentation.
  6. Pay as much as you can as early as possible; every dollar paid reduces the base on which interest is calculated.

When to call a professional

If your tax debt exceeds a few thousand dollars, your situation includes business accounts, or you’ve received a levy or notice threatening imminent collection, get professional help. In my practice I often find that a focused application for an OIC or a properly structured IA saves taxpayers thousands versus DIY attempts.

Authoritative sources and further reading

Related FinHelp articles

Professional disclaimer

This article is educational and does not replace personalized tax advice. Tax law and IRS procedures change; verify current rates and program details on the IRS site or consult a qualified tax professional before acting.

Final takeaway

Penalties and interest will usually continue to grow until you reduce the unpaid principal. The right plan depends on your ability to pay now and in the future: Installment Agreements reduce enforcement and spread payments, Offers in Compromise can eliminate a portion of debt if you truly cannot pay, and CNC buys time when you need immediate relief. Acting quickly, filing on time, and documenting your situation give you the best chance to limit extra costs.