Credit, Debt, and Taxes: What You Should Know

By Mike Peterson
In April 12, 2013

The official IRS deadline is nearly here (it’s April 15 – unless you’re planning to file for an extension), but it’s never too late to talk about some of the ways that income taxes can affect your life – and your credit.

 

For example, did you know that certain types of credit card rewards are considered taxable income?  Or that paying your taxes late can hurt your credit score?  Ever wonder why most financial experts say you shouldn’t (ever!) pay your tax bill with a credit card?

 

Want to learn more?  Keep reading.  Here are five things you might not know about the relationship between your income taxes and credit.

 

  1. If you don’t pay (or pay late), your credit score will take a nosedive.  You probably already know that if you don’t pay your taxes, you’ll start accruing interest and late fees.  You’ll get letters and possibly phone calls from the IRS, reminding you of your outstanding debt.  This is just the first step, though:  If you ignore the fees and letters long enough, Uncle Sam will file a tax lien against you.  This basically means that the IRS is telling the world that you owe them money.  A lien is public information – and it will go on your credit report.  Your score will go way down, and you’ll find it more difficult to get financing for a home, obtain loans, and so on.

 

If you don’t have the extra cash to pay your tax bill, the best thing to do is contact the IRS directly – and immediately.  Explain your situation, and try to make some sort of arrangement, such as breaking up what you owe into an installment plan.  Don’t wait.  Don’t ignore the problem.

 

Until recently, one of the worst things about a tax lien was its staying power — but that’s changing, thanks to the IRS’ new “Fresh Start” program, which is our next item on the list . . .

 

  1. You can apply for a “fresh start” – but you have to ask.  Traditionally, once you had a tax lien on your record, the only way to make it go away was to pay your debt – and then wait seven years for the lien to be wiped away.  And no, that’s not a typo:  Under the old rules, your lien remained on record for seven years after the day you paid your debt in full.  That’s a long time – especially if you’re trying to improve your credit score.  In 2011, things changed a bit:  The IRS instituted its “Fresh Start” program, which basically lets you request the lien be erased from your record as soon as you pay what you owe – no more seven-year waiting period.  Doing this can dramatically improve your credit rating.  The only catch is that you have to file a formal, written request to take advantage of the program – if you don’t ask, the old rules apply and the lien will stick around for the full seven years.

 

As part of the program, you can also request that the IRS formally notify certain organizations – such as credit card companies or credit reporting agencies – of your new, debt-free status.  For more details about the program, check out this page on the IRS’ website.

 

  1. “Forgiven” debt is not “forgotten” debt.  Let’s say you’ve been struggling with $10,000 in credit card debt.  After a long, drawn-out negotiation process, you finally came to an agreement with your credit card lender:  You paid $3,000, and in exchange for that payment, the remaining $7,000 was forgiven.

 

The good news?  You’re no longer responsible for making payments.  You’re in the clear, and you won’t receive any more collection notices or harassing phone calls.  The bad news?  You’ll receive a 1099-C form from the credit card company, and Uncle Sam will also get a copy.  Basically, that “free” $7,000 will be added to your income for the year, and you’ll pay taxes on it, just as you would if you earned money at a job. 

 

That’s not the only surprising way your credit cards can affect your taxes, though.  Let’s take a look at rewards programs next.

 

  1. Some (but not all) credit card rewards are taxable.  I won’t get into a debate about whether credit card rewards programs are worthwhile or not (you can weigh the pros and cons yourself in this post).  But if you do have a rewards card, it’s important to know how those rewards can affect your taxes. 

 

Here’s a quick and easy breakdown:  Traditional rewards – in other words, rewards that you earn by using your credit card – are not considered taxable income.  As long as those rewards points or airline miles are directly tied to your spending activity, you’re in the clear.  But if those rewards were freebies (for instance, if you earned, say, 50,000 free airline miles simply for opening a new credit card), you may owe.  To determine this, the IRS looks at the overall value of your “free” gift:  If it’s worth $600 or more, the IRS considers it a “taxable property windfall.”

 

  1. Using a credit card to pay your taxes is a really, really bad idea (really!).  Typically, people use credit cards to pay the IRS for two reasons:  They want to leverage their large-ish tax bill to earn airline miles (or cash back, or rewards points), or they don’t have the cash to pay Uncle Sam outright.  Both of these reasons are bad, and if you’re considering doing this for either reason, I’d strongly recommend that you don’t do it. 

 

First of all, using your credit card to pay your taxes may score you a few extra air miles – but it can also have the unintended effect of making you look like a high risk to your credit card company.  And if your credit card company views you as high-risk, they might decide to lower your credit limit or raise your interest rate.  Another surprising consequence?  Tax-related credit card debt doesn’t go away – even if you file bankruptcy. 

 

The best option is to pay your taxes – in cash.  If you don’t have the money, get in touch with the IRS right away and work out a manageable payment plan before it’s too late.

 

Bottom line:  Pay your taxes – on time, and in cash (even if you have to set up an installment plan).  Leave credit cards out of it.  I can’t promise that these tips will totally take the sting out of your 2012 tax bill – but they can help ensure that you don’t end up paying more in the long run.

Mike Peterson

Mike is the author of “Reality Millionaire: Proven Tips to Retire Rich” and he has been published in a variety of local and national publications including Entrepreneur Magazine, Deseret Morning News, LDS Living Magazine, and Physicians Money Digest. He holds a B.S. in business administration from the University of Phoenix.