How Taxes Can Affect Your Credit & How to Be Prepared for Tax Season

shutterstock_156563393
Most people don’t like paying taxes. And it seems like the only thing people like less than having taxes taken out of their paycheck is having to write a check to the government because they didn’t withhold enough. Maybe that’s why so many people withhold far more tax money than they need to. That money has been called a tax free loan to the government, but withholding too much money as opposed to not enough may not be as irrational as some people would like to make it out to be.

Let’s make up someone. We’ll call him Noah. If Noah withholds just the right amount, Noah wouldn’t owe anything, and he wouldn’t get a refund. He would have extra money every month to spend on the things he wants. But how would Noah know how much he needs to withhold? If he’s self-employed, owes alternative minimum tax, or “certain Other Taxes” he should use IRS publication 505. Otherwise he can just use the IRS Withholding Calculator to figure out how much should be withheld each check.

This would seem to be the perfect situation, except Noah is someone who consistently has too much month left when he runs out of money. That makes it hard to save. So, Noah consciously chooses to pay too much in taxes. It’s probably not the way a financial planner would tell Noah to save, but by paying too much Noah essentially forces himself to save and then, when tax season rolls around, he gets a check which he can use for something he wouldn’t have the money to do otherwise, like a vacation, or a new TV, he might even surprise everyone and put it in savings or invest it.

But, let’s assume that Noah makes a mistake. And he comes up short for his 2015 taxes, far too short to make up in the difference between what he actually has and what he owes before the April 15 tax day deadline. What will Noah do? I’m guessing he’ll panic. Yep, definitely panic.

Why panic? Because owing the government money has definite impact on credit, along with your life and mental health. But, in this post we’re just going to talk about his credit.

Once Noah is done panicking, he should still fill out his tax forms and pay what he can. Then Noah, or someone he authorizes, should contact the IRS to let them know why Noah was unable to pay the full amount. It is possible Noah could end up on a payment plan; or he might enter into a dispute if he thinks the amount he owes is incorrect; or if his circumstances are extreme enough the amount he owes might get waived altogether.

But let’s assume that Noah doesn’t contact the IRS at all, he just hopes it will all go away. Now what? The IRS will typically send him a bill, followed by a second bill if there is no response to the first. They might even send a third bill, a fourth bill, or even more. But, eventually, if Noah doesn’t respond the IRS will start the collection process. The IRS has several ways that they can attempt to collect the money that is owed them, but we’re only going to talk about liens.

A lien is a claim against property, like wages, salary, commissions, bank accounts, federal payments, house, car or other property. And it attaches to the property when filed. Although the IRS doesn’t typically report those, credit bureaus often seek those out and report them anyway.

A lien is different from a levy. A lien basically says “you owe me money, so I can take your property to collect what you owe me if I need too.” A levy is when they actually take the property. A lien of any kind can often make it harder to get credit to buy a home or a car, to find a place to rent, or even get a job.

The reason a lien makes it harder to get credit is that when it comes time to get paid, creditors basically have to stand in line. The people at the front of the line get paid first while the people at the back get paid last. And the further back you are, the less likely you are to get paid. And a lien secures the place of the IRS in that line, letting future lenders know that they’re less likely to get paid because they’re further back in line.

When the IRS files their lien against Noah, they will send him a notice within five days of the filing and include a date by which he can request a hearing. A notice of federal tax lien also shows the amount assessed as of the date of the notice. An individual should contact the IRS to get the actual amount that must be paid when they are ready to pay off the lien and have it released.

If Noah requests a hearing, the IRS would determine if the lien against Noah’s stuff should remain filed, or be withdrawn, released, discharged, or subordinated. And if Noah disagrees he has 30 days to seek a review in the U.S. Tax Court. In addition to disagreeing with the amount of the lien, Noah could actually appeal the lien itself, even if the IRS has only proposed that a lien be filed.

We’ll pretend that Noah appeals and loses. Now what? Well, the lien stays on Noah’s credit reports. Most negative items can remain on a credit report for around seven years. But, unlike most items on a credit report, an unpaid lien can potentially remain on a report far longer than seven years. An unpaid lien remains as long as it is filed and remains effective.

A few years later, Noah, by a stroke of luck, happens to come into some money, so he pays off his tax lien. Now that the tax lien has been paid the seven year clock begins to run, starting from the date of payment.

So, now Noah is stuck with a lien on his credit report for another seven years? Not necessarily. Noah can file an “Application for Withdrawal of Filed Notice of Federal Tax Lien (IRS form 12277). In fact, under the right circumstances Noah can apply for a withdrawal even if the lien hasn’t been paid off. In that case he’ll still owe the lien, but it will no longer appear on his credit report.

And now Noah is probably wishing that he had saved too much for 2015 instead of too little. So overestimating how much you’ll need to pay is not necessarily a bad thing. But even more important is, if you find you are unable to pay your tax bill, be proactive in contacting the IRS, explaining the situation, and getting the matter worked out so that you can minimize its impact on your life and your credit.

So, what can be done to avoid ending up like Noah. There are couple of tips that can help.

Check it every time your financial situation changes, like when you change jobs, get a raise, get married or divorced, or have a child, to make sure your withholding enough, but not too much.

  • Adjust your w-4 as necessary.

Once you’ve determined the size of your refund, or the check you’ll have to write, fill out a new W-4 with your employer and make the changes appropriate to it at this point in your life.

  • Gather all your tax forms into one place as they arrive. Most of them should arrive by the end of January.

Have a specific place to keep the data as it comes in, like a folder or an envelope that you keep on one shelf or in one drawer.

  • Do your taxes early.

The advantage of doing your taxes early is you’ll know if you’re getting a refund, and can have it that much sooner. And, if you’re going to end up paying, at least you know how much you owe, and can adjust your finances accordingly, if necessary, to make sure you have enough in the bank to cover the tax check.

  • If you can’t pay your tax bill contact the IRS yourself, or have some else do it for you, to work out a solution.

The worst thing you can do is ignore your tax bill. By proactively contacting the IRS you increase your available options for finding a solution that will work best for you.

At Lexington Law Firm we are dedicated to helping you make sure your credit reports are fair and accurate. If you have negative items on your credit report that are holding you back from reaching your financial goals, give us a call we may be able to help.

(For more about IRS Collection methods see publication 594. For more about tax liens see the IRS publication Understanding a Federal Tax Lien.)

 

Related Articles:

Paying Taxes With a Credit Card: The Do’s and Don’ts

Taxes and Credit Repair: 5 Ways to Use Your Refund Wisely

Do taxes affect your credit score?