Debt and Taxes: What You Need to Know 

Who doesn’t love getting a tax refund? It can be a rare chance to have one lump sum of funds to meet a goal – whether that’s bolstering savings, paying off a credit card, or taking a dream vacation. But before you decide how to use it, it’s important to understand how debt and taxes are connected. From using your refund to chip away at what you owe to dealing with the tax impact of forgiven debt, these financial decisions can have a big impact.  Here’s the scoop, and a couple of pitfalls to avoid. 

Forgiven debt can be taxable. 

Old debts in collections can often be settled for less than the full balance. For some, this can help your savings (or tax return) stretch to get you closer to being debt-free. 

For example, if you had an old credit card debt in collections with an $8,000 balance, you could negotiate a settlement, agreeing to pay only $5,000 instead of the full amount. However, the $3,000 difference can be considered taxable income. If you receive a 1099c on the debt, make sure to give it to your tax preparer or enter it if self-filing.

Consider how this could impact your tax refund. Unless you are settling a very large amount, it’s unlikely to put you into a different tax bracket, but… I have seen scenarios where a family withdrew retirement funds to settle a large debt. Between the tax consequences of both, they ended up with a very sizable amount due in taxes. 

Are there exceptions – debt that is not taxable? 

Yes. Debt discharged through bankruptcy cannot be collected. Likewise, forgiven mortgage debt (such as through a short sale or deed in lieu) needs to be reported on taxes, but is generally not included as taxable debt. While plans for the bulk of student loan debt are still under discussion, loans forgiven under the Public Service Loan Forgiveness program are not taxable.  

Your taxes can help with your debt. 

Tax season can be a great chance to make strides toward your debt-free goals. If you’re carrying high-interest debt (the average credit card balance today is over $6,000), then getting that paid down is a priority for managing your financial portfolio. 

Start by creating an emergency savings account. That way you don’t need to open a new debt in case of an emergency. Beyond that, it makes financial sense to put funds toward debt.

Even high-yield savings accounts have only about a quarter of the interest rate compared to average credit card costs. So create or replenish your emergency savings, and then pay down high-interest debt with that tax refund. 

What to do if you owe a large tax balance? 

First, don’t ignore it. The IRS charges an annual interest rate on unpaid balances and a monthly penalty fee. Contact the IRS (and/or state) directly to ask about setting up a monthly repayment plan.

Interest rates on delinquent taxes average 3-4%, and the penalty fee is about 0.5% of the balance monthly. These rates are generally cheaper than moderate-to-high-interest loans. Repayment plans are commonly 1-3 years but can be longer in exceptional cases or with very large amounts due. As this is interest-bearing debt, the goal is to create a feasible payment plan that helps you pay it off sooner rather than later. 

Bonus ways to save more

You can also make the most of your tax dollars by utilizing free quality tax preparers if available in your area. Check out VITA for more information. 

Be cautious about paying to get your refund early. Like any other cash advance service, it generally comes at very high fees, averaging 35% annual interest. Plus, if your refund is less than the preparer anticipated, you must repay the difference. Having a game plan ahead of time for your taxes and potential tax refund is key for making the most of these seasonal dollars. 

💡Action Item: This week, aim to check out options for tax preparation near you and make a list of what you’d like to accomplish with your refund. Get your goals down on paper with a prioritized list of where you’d like to see the funds go, depending on the refund amount. 

Or if you may need to pay in taxes, add that to your spending plan. Aim to make the most of your taxes this season!