Overview

When you enter an IRS installment agreement to pay a tax liability over time, the debt does not stop growing. The IRS continues to charge interest on the unpaid balance every day, and it may assess penalties for late payment or for a previously unfiled return. Knowing which charges apply, how they are calculated, and which practices reduce cost can materially change the total you pay.

(Author’s note: In my work as a financial educator advising more than 500 clients on tax repayment strategies, the two most common avoidable mistakes are assuming penalties stop after an agreement is set and not using direct debit to reduce penalty rates.)

How interest is calculated

  • Interest is charged on the unpaid tax and generally accrues daily until the balance is paid in full. The IRS interest rate for underpayments is set quarterly and equals the federal short‑term rate plus 3 percentage points for individual underpayments; interest compounds daily. For current rates see the IRS interest page. (IRS: Interest Rates for Underpayments and Overpayments: https://www.irs.gov/newsroom/interest-rates-for-underpayments-and-overpayments)
  • Practical calculation: to estimate daily interest, divide the annual rate by 365 and multiply by the outstanding balance. For example, at a hypothetical 6% annual rate, a $10,000 unpaid balance would accrue about $1.64 per day (0.06/365 × $10,000).

Key points:

  • The interest rate can change quarterly, so the daily accrual can change during your agreement.
  • Interest applies to tax, penalties, and certain additions, so penalties themselves can accrue interest.

The main penalties that can apply

  1. Failure‑to‑File Penalty
  • If you did not file a required return on time, the failure‑to‑file penalty (generally 5% of the unpaid tax per month, up to 25%) may apply. This penalty is generally assessed from the date the return was due until it is filed.
  • Because the failure‑to‑file penalty is often larger than the failure‑to‑pay penalty, filing on time (even if you cannot pay) limits total charges. (IRS: Penalties: https://www.irs.gov/payments/penalties)
  1. Failure‑to‑Pay Penalty
  • The failure‑to‑pay penalty is generally 0.5% of the unpaid tax per month (or partial month) up to 25% of the unpaid tax. This penalty accrues in addition to interest.
  • Reduction for certain installment agreements: If you set up a direct‑debit installment agreement (DDIA), the monthly failure‑to‑pay penalty rate is reduced to 0.25% per month (up to the same 25% cap) while the agreement is in place. This reduction is automatic for qualifying DDIA arrangements. (IRS: Installment Agreements: https://www.irs.gov/payments/installment-agreements)
  1. Other Penalties and Additions
  • Trust fund and payroll tax deposits, excise taxes, and other specific tax types can carry higher penalties and different rules. For employment taxes, penalties for failure to deposit can be assessed before an installment agreement is even offered.
  • Revocation or default of an agreement can trigger immediate collection actions (liens, levies, offset of refunds) and additional charges.

Interaction of interest and penalties

Interest compounds on both tax and penalties. That means a penalty assessed today will itself begin to accrue interest from the date of assessment, increasing the effective cost of the original tax debt. Because interest is set by statute and changes periodically, small changes in rate can still add up over long agreements.

What happens if you miss a payment or default

  • Missing a scheduled payment can lead to late‑payment penalties and possible termination of the installment agreement. Termination exposes the taxpayer to full collection actions and reinstates standard penalties and interest.
  • If you foresee a missed payment, contact the IRS before the due date to request a modification or short‑term relief. Documentation of hardship may be required.

Options that reduce penalties and interest costs

  • Use Direct Debit: Enrolling in a DDIA is one of the most cost‑effective steps; it reduces the monthly failure‑to‑pay penalty and lowers default risk. (See our guide: Enrolling in an Online Installment Agreement: A Step‑by‑Step Guide: https://finhelp.io/glossary/enrolling-in-an-online-installment-agreement-a-step-by-step-guide/)

  • Pay more than the minimum: Paying extra toward principal reduces daily interest accrual and shortens the period you pay penalties.

  • Apply federal refunds and credits: You can ask the IRS to apply future refunds to your unpaid balance, which reduces principal and subsequent interest.

  • Look for penalty relief: The IRS offers administrative relief options such as First‑Time Penalty Abatement (FTA) for eligible taxpayers and reasonable‑cause relief when circumstances justify abatement. Eligibility and documentation requirements vary. (IRS: Penalty Relief and Abatement: https://www.irs.gov/payments/penalty-relief)

  • Renegotiate or modify the agreement: If your financial situation changes, request a modification rather than missing payments. See our related article: When and How to Modify or Revoke an Installment Agreement: https://finhelp.io/glossary/when-and-how-to-modify-or-revoke-an-installment-agreement/

Examples and a sample calculation

Example 1 — Basic interest + penalty illustration (rounded figures):

  • Unpaid tax: $12,000
  • Annual interest rate (hypothetical): 6% (0.06)
  • Failure‑to‑pay penalty while not on DDIA: 0.5% per month
    If you make no payments for one month: interest ~ $60 (0.06/12 × $12,000) and penalty = $60 (0.005 × $12,000). The next month interest is calculated on $12,120 (original + penalty + interest), so charges compound.

Example 2 — Direct debit benefit:

  • Same $12,000 balance, but you enroll in DDIA: penalty rate = 0.25% per month instead of 0.5%. The first‑month penalty would be $30 rather than $60, and over a multi‑year term this reduction can save hundreds to thousands of dollars.

Note: These examples use round figures and hypothetical interest rates. Check the IRS page for the current quarterly rate before final calculations. (IRS: Interest Rates for Underpayments and Overpayments: https://www.irs.gov/newsroom/interest-rates-for-underpayments-and-overpayments)

Common mistakes and how to avoid them

  • Mistake: Believing penalties stop once an agreement is filed. Reality: Penalties and interest generally continue unless specifically abated.
  • Mistake: Choosing a non‑direct‑debit plan without understanding penalty implications. Reality: DDIA typically lowers penalty rates and lowers the chance of default.
  • Mistake: Not documenting reasonable‑cause events. Reality: To request abatement you will need clear documentation (hospitalization, natural disaster, or other qualifying events).

Practical checklist before entering or modifying an agreement

  • Verify the current IRS interest rate and recent trend on the IRS interest‑rate page.
  • Ask for a direct‑debit plan when applying.
  • Provide complete and accurate financial information if requesting a low‑payment plan.
  • Keep copies of all correspondence and set calendar reminders for payments.
  • Consult a tax professional if you have large balances, payroll tax issues, or if collection activity has already started.

When to seek professional help or additional IRS assistance

  • If the liability includes employment taxes, or if liens/levies are active, work with a CPA, enrolled agent, or tax attorney.
  • If you face hardship or believe IRS procedures were applied incorrectly, you can contact the Taxpayer Advocate Service for independent help. (IRS: Installment Agreements: https://www.irs.gov/payments/installment-agreements)

Frequently referenced authoritative sources

Professional disclaimer: This article is educational and does not constitute legal or tax advice. Individual tax situations differ; consult a tax professional before making decisions. In my practice I prioritize direct‑debit agreements, prompt filing, and quick principal payments to minimize total cost — these steps consistently reduce penalties and interest for most taxpayers.

Internal resources:

Keywords: IRS installment agreement, failure‑to‑pay penalty, interest on unpaid taxes, penalty abatement, direct debit installment agreement.