Preparing for Tax Season: Understanding How Taxes Affect Your Credit

The effect taxes can have on your credit

Most people don’t like paying taxes, and many people withhold far more tax money than they need too. 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 wouldn’t get a refund. He would have extra money every month to spend on the things he wants.

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.

Consider a different scenario: Noah consciously chooses to pay too much in taxes. 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.

But, what if Noah makes a mistake and comes up short for his taxes? Not too short, but far too short to make up the amount before the April 15 deadline. What will Noah do? Hey may panic. After all, owing the government money has a definite impact on your life, mental health and even your credit.

What to Do if You Owe

Sure, panic may be the natural reaction if you find yourself in Noah’s situation, but take a deep breath. If you discover you’re going to owe, you should still fill out your tax forms and file them. (Make sure you do so on time so you don’t get hit with owing a penalty fee for being late.) Figure out how much you can pay and then you can contact the IRS to let them know the situation and why you don’t think it’s possible for you to pay the full amount right away. You might end up on a payment plan. Or, if you think the amount the IRS is reporting you owe is incorrect, you might enter a dispute. If your circumstances are extreme enough, the amount your owe might get waived altogether.

It’s Important to Communicate

It can be scary to pick up the phone and contact the IRS, especially if you feel you’re delivering bad news. But if you don’t, hoping this is all a bad dream or that it will simply go away, you could open yourself up for bigger problems. The IRS will typically send a bill, followed by a second bill, and possibly a couple others. But if their attempts at communication go unanswered, the IRS will eventually start the collection process, which can result in a lien.

A lien is a claim against your assets — that can be things like your wages, salary, commissions, bank accounts, federal payments, house, car or other property. Once a lien is filed, it attaches to the given asset(s) and can appear on your credit reports. Note: A lien (a statement of “you owe me money, so I can take your property to collect what you owe me if I need too”) is different than a levy (when the asset is taken).

How Liens Impact Your Credit

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, logically, the people at the back get paid last. A lien secures the place of the IRS in that line, and it lets future lenders know that they’re less likely to get paid because they’re further back in line.

Once the IRS files a lien, they will send a notice that includes a date by which you can request a hearing. If this is what you opt to do, the IRS determines if the lien should remain filed, or be withdrawn, released, discharged or subordinated. If you disagree with their decision, you have 30 days to seek a review in the U.S. Tax Court. In addition to disagreeing with the amount of the lien, it’s also possible to appeal the lien itself, even if the IRS has only proposed a lien be filed. (Note: If you appeal and it doesn’t go in your favor, the lien will stay on your 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 as long as it is filed and remains effective.)

Paying the Lien

A notice of federal tax lien also shows the amount assessed as of the date of the notice, but it’s a good idea to also contact the IRS to verify the amount that must be paid to pay off the lien and have it released. Once you pay off your tax lien, the seven year clock begins to run, starting from the date of payment. You can also file an “Application for Withdrawal of Filed Notice of Federal Tax Lien (IRS form 12277). In fact, under the right circumstances, you can apply for a withdrawal even if the lien hasn’t been paid off. In that case, you’ll still owe, but won’t see the lien appearing on your credit report.

Tips to Help You Prepare for Paying Taxes

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 you can minimize its impact on your life and your credit.

Here are couple other tips to help you prepare for paying taxes.

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 have more time to save for that bill.

  • If you can’t pay your tax bill contact the IRS to work out a solution.

One of the worst things 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 for you.

At Lexington Law, we’re 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.)

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