04/12/2013 03:48 pm ET | Updated Jun 12, 2013

What You Need to Know About Filing a Tax Return Extension

It's the last few days of tax season, and if you're planning to file an extension because you might owe taxes, remember that an extension only gives you additional time to file forms. Filing an extension does not give you any additional time to pay your taxes. Even with an extension, you must still pay your taxes by April 15 or pay a penalty for not paying on time.

Now that that's out of the way, let's review why folks file extensions. The quick answer is, there are many reasons: people may still be waiting on documents, they may not have the money to pay the taxes they owe with their return or they simply may just not be ready and need extra time. Extending is fine if you really need to.

However, the tax code is not set up to just give you extra time if you are not ready file. The government is ready, so the rules for delaying your tax obligation are not as favorable as other areas of the tax code. Let me explain.

The tax code is set up to assess a penalty for both late-filed returns and late-paid taxes. The failure-to-file penalty for late-filed returns is five percent of the unpaid taxes each month or part of a month the return is late. If you file your taxes more than 60 days after the due date, the minimum penalty is $135 or 100 percent of the unpaid taxes. The good news is that the failure-to-file penalty can't exceed 25 percent of your unpaid taxes.

The bad news is that in addition to the failure-to-file penalty, there is a failure-to-pay penalty that is assessed each month, or part of the month, your taxes aren't paid. This penalty is one half to one percent of the unpaid taxes each month, or part of a month, the balance due remains. The maximum failure-to-pay penalty is 25 percent of your unpaid taxes.

If you have at least 90 percent of your actual taxes paid on or before April 15 and you file an extension on or before April 15, you will not be assessed a failure-to-pay penalty as long as you pay the remaining taxes on or before October 15.

The IRS compounds interest daily and penalty assessments monthly. Compounding interest and penalties simply means the amount assessed today becomes part of your principal tomorrow and is subject to the next assessment for interest and penalty. So you can count on any balance due to the IRS to grow rapidly.

For example, in April a taxpayer owed $500 in taxes, which resulted in a penalty assessment of $25. The taxpayer was then assessed a total of $40 in interest during the month of April. The new principal subject to penalty in May is already $565 - a 13 percent increase in just one month.

If you are subject to both the failure-to-file and the failure-to-pay penalties in any month, you will be assessed no more than the total failure-to-file penalty for that month.

So filing an extension can remove the failure-to-file penalty, which is the larger penalty on a monthly basis, but it will not remove the failure-to-pay penalty.

If you're filing for an extension the right way, you already have your tax information together, and you've determined you have to pay and how much. Why not just file your taxes and mark it off your to-do list? This will help save you the aggravation of doing your taxes twice, once to file the extension, and then to finalize your filing. So extend if you have to, but know the important considerations, and avoid trouble.