What To Do When Your Taxes Jump Because Of Settled Debt

5 June 2019
 Categories: , Blog

Settling old debt can be a relief, especially once the money is out of your account and the bills and calls stop. However, in the United States, settled debt brings with it another issue: extra taxes. Yes, you owe taxes on the forgiven portion of your debt because that's considered extra income.

When you settle, you pay part of the total due, and the unpaid part is forgiven. Because you're no longer sending your income out to pay that debt, it's the equivalent (in the IRS' eyes, at least) to suddenly getting a nice windfall -- just one that appears over time, rather than all at once. That "over time" quality does not stop the agency from demanding all the taxes on the amount at once, however. If you settle debt, start planning now for the tax consequences.

Increase Estimated Tax Payments

First, you have the opportunity to pay taxes on the amount early in the form of estimated taxes. You don't have to wait for a particular deadline; in fact, a tax accountant can help you figure out the approximate amount you'd owe, and you can send in part or all of that money earmarked as estimated taxes. Keep a record of the payment, especially the date, because your tax return for this year will require that information.

Increase Withholding

If you have a traditional W-2 job (as opposed to a 1099 contractor job), go to your payroll department and fill out a new W-4. Increase your withholding. If you're single and have no kids, you can claim zero deductions on your W-4. Your paycheck will be smaller, but the amount of taxes withheld will chip away at the amount you'll owe for that forgiven debt.

Call About Payment Plans

If, after increasing withholding and paying some estimated taxes, you still have extra taxes to pay, pay what you can at the time you file your tax return for this year. If there is still an amount due left after that, you can set up a payment plan with the IRS. Yes, that does mean you'll have another debt. But you'll have already taken steps to minimize what you owe, and you can pay off the debt early whenever you want.

Don't take any of this as a hint that you shouldn't settle. You can save a lot of money and give yourself priceless peace of mind by settling. You do want to be aware of the results, however, to ensure you don't end up back in a situation where you are now saddled by more untenable debt. Meet with a tax planning specialist to find the best ways to get those taxes paid ahead of time.