Forgiven credit card debt leads to a big tax bill

Money Talk

Dear Liz: My husband racked up more than $17,000 in credit card debt and negotiated a settlement for $4,000 last year. We received a 1099-C form for $13,000 of forgiven debt, which we have to claim as income. That puts our modified adjusted gross income over the threshold of being able to claim tuition and college expense deductions for our three kids and myself. We now owe more than $11,000 in taxes and we don't have the cash to pay. Any advice would be greatly appreciated.

Answer: You may think owing an $11,000 tax bill because you saved $13,000 on a credit bill is bad enough. But the ironies just keep coming.

The best way to pay this bill may very well be by credit card, if you still have one with a sufficient credit limit. As the IRS puts it, "The interest rate and any applicable fees charged by a bank or credit card are usually lower than the combination of interest and penalties imposed by the Internal Revenue Code."

The IRS penalty for nonpayment is 0.5% a month and the interest rate is 4% a month. Considering that, even a 20% credit card interest rate looks like a bargain.

Of course, you may have access to other, cheaper credit, such as a home equity line of credit. If not, and you don't have space on a credit card, you'll need to work something out with the IRS.

If you owe less than $25,000, you can file online for a short-term (120 days) extension or a longer-term installment plan. You'll find more information at http://www.irs.gov/taxtopics/ tc202.html.

Whatever you do, don't use this problem as an excuse not to file your tax return, since the failure-to-file penalty (5% a month) is 10 times as much as the failure-to-pay penalty.

A trick to boost credit scores

Dear Liz: We charge essentially all our purchases, totaling several thousand dollars a month, on two credit cards. We're in the habit of paying off the balances about two days before the statement closing date.

Naturally, when we receive our next statements, the remaining balances are very low, and those low balances are reported each month to the credit bureaus. Our FICO credit scores are above 800. Does the way we're paying our cards actually help our scores?

Answer: Absolutely. The FICO credit scoring formula is sensitive to the gap between your available credit and the credit you're actively using, as represented by the balances your issuers report to the credit bureaus. The bigger the gap, the better, and paying off your balance a few days before the statement closing date each month is a good way to reduce the reported balances.

Just make sure to make a second payment to pay off the remaining balance before the due date. Otherwise you may face late payment penalties and interest charges.

Should retiree dip into 401(k)?

Dear Liz: You responded to the question "Should I take $50,000 from my 401(k) to pay off the debt?" with a resounding no. However, part of the rationale was how much the money could grow if it were left alone. That makes sense for a young person, but how would you answer the same question for someone retired at age 66?

Answer: At that age, you wouldn't face tax penalties for early withdrawal and you're probably giving up less in future gains than someone who is younger.

But dipping into a 401(k) to pay unsecured debts may still be a bad move if there is any chance you'll wind up in Bankruptcy Court, because retirement funds are protected from creditors. It's also unwise if you would be withdrawing a large part of your nest egg, because this money has to last you the rest of your life.

A visit with a fee-only planner can help you decide whether using your retirement money this way makes sense. You can get referrals from www.garrettplanningnetwork.com or www.napfa.org.

Liz Pulliam Weston is the author of the book "Your Credit Score: Your Money and What's at Stake." Questions for possible inclusion in her column may be sent to 12400 Ventura Blvd., No. 238, Studio City, CA 91604, or via the "Contact Liz" form at www.asklizweston.com. Distributed by No More Red Inc.

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