Debt Settlements and Taxes

Understanding Debt Settlement

When consumers find themselves falling further and further behind on their credit card payments, many turn to debt consolidation programs for help. By working with a credit counselor, your credit card debt can be combined into one monthly payment that is usually lower than making several payments to different creditors each month.

The problem consumers may find with this type of program is that it doesn’t help reduce their debt. Making these lower monthly payments can take years before you see a debt reduction.

Debt settlement, however, can actually reduce the amount of debt you owe. By negotiating with your creditors, you may be able to get your total amount of debt lowered to a more realistic goal. Creditors are willing to take the lower amount rather than not receive any payment at all or to receive small payments over the course of years. You can typically only use this method if you have over $10,000 of debt and are unable to make your monthly payments.

Often, consumers to choose to work with a settlement program negotiator who will charge you a fee for this service.

Debt Settlement and Taxes

Although getting a large chunk of your debt erased can be a great relief, the Internal Revenue Service also sees it as income. Just like you have to pay taxes on an inheritance or lottery winnings, you also need to pay tax on the amount of your debt settlement.

The IRS allows the first $600 of debt settlement to be tax free. If you only have $600, you are in luck and won’t have to pay any taxes. Of course, if you only had $1,200 of debt to begin with and could get it reduced to $600, you probably wouldn’t be using a debt settlement program in the first place.

As a better example, let's say you had about $12,000 in debt and got the total reduced to $6,000.

• Since the IRS does not include the first $600, you will have to pay taxes on $5,400.
• If you are in a 30 percent tax bracket, that means you owe $1,620 in taxes just for this forgiven debt. This does not include any penalties you may have to pay for under withholding federal taxes during the year.
• If you go through an agency to get your debt reduced, it may charge as much as 50 percent of what you saved as a fee for service. Thus, it may require $3,000 to save you $6,000 in debt.

Combined with the $1,620 in taxes you will have to pay, you have actually only reduced your debt by $1,380. The debt settlement program may not seem like such a great bargain now.

Why Does It Matter?

Depending on how much your debt settlement is, you could be in for a big surprise at tax time. You will receive a form from your creditor detailing the amount of settled debt that will be included as income on your annual taxes.

The amount of tax you need to pay will vary depending on your other tax factors, like your filing status and deductions. But if you have a large amount of debt settlement, say $20,000 or more, it could push you into the next tax bracket, making your overall income tax higher.

Since this could eat into your tax return or make you owe the government, this puts you in a sticky situation. Using our example above, the $6,000 that was erased from your debt was going to be paid slowly over time. The $5,400 you now have to pay taxes on is due on April 15, no exceptions. If you can not pay it, you could end up back in financial trouble.

So where does all of this leave you? Confused, probably. It is a lot to weigh, especially when you are already faced by increasing debt and collectors harassing you on the phone.

What to Do

Although you most likely don’t want to pay out the money, consulting with a tax attorney may be your best bet before you agree to a debt settlement program. Since the program will usually charge a percentage of the amount that gets erased, a fee that can be as much as 30-50 percent, you may not save a lot in the long run. Having a professional review your taxes and estimate how much you owe can help you decide if the program is worth it.