Tax season always brings a considerable number of questions. One of the most common relates to taxes and credit scores. Can not paying your taxes hurt your credit score? Conversely, can paying your taxes help boost your score? Here’s everything you need to know:
How Paying Your Taxes Can Hurt Your Credit Score
Yes, paying your taxes can impact your credit score. In fact, In some instances paying your taxes will have a greater impact on a credit score than not paying. Paying your taxes can harm your credit score in particular cases. These cases involve failure to pay on time, having too much debt, and other similar problems. Here’s a quick breakdown of the three major repayment options for anyone who owes the Internal Revenue Service (IRS) money:
|Repayment Method||Potential Credit Impact|
|① Installments||Installment agreements are the best way to repay back taxes, as they follow well-defined payment practices and allow you the opportunity to repay your back taxes at a fixed rate that works for you. The IRS does not consider an installment repayment plan as a personal loan, so the repaying (or non-repaying) of your back taxes will have no impact on your credit score.|
|② Credit Card||Credit cards may seem like a good idea, but using them to pay your taxes can seriously harm your credit if you aren't paying back what you owe - on time, and in full. Credit cards have high-interest rates (usually above 20% APR) meaning paying back taxes can accrue significant interest quickly.|
|③ Personal Loan||Paying back taxes with a personal loan can seriously impact your credit score if you aren't careful. These loans typically offer much lower interest rates than a credit card loan, but failure to repay your tax burden - and the loan amount - can cause double damage to your credit score.|
Paying Taxes with a Credit Card
The most basic way to pay your taxes can negatively impact your credit score by increasing your credit utilization ratio. Because the IRS allows taxpayers to settle any outstanding tax bills through a credit card, choosing this payment method can significantly increase taxpayers’ credit utilization.
What is credit utilization? Simply put, the credit utilization ratio is a percentage of how much of your total available credit you are using. Credit utilization has the second-largest impact in determining your credit score. Approximately 30% of a FICO score comes from credit use. This trails only payment history (35%) as the most important credit score factor.
Paying taxes with a credit card can significantly raise a person’s credit usage, leading to a drop in their FICO or VantageScore credit score. Of course, these drops all depends on a few factors:
- The size of the outstanding tax balance
- The credit limit of the cardholder
- How much outstanding credit card debt the taxpayer already holds
If the taxpayer pays off their new balance ahead of schedule or ensures they never make a late payment, the negative credit score impact will dampen over time.
Paying Taxes with a Loan
When a tax bill is much higher than expected, it might be challenging to cover the costs – even with a credit card. Some taxpayers might turn to a personal loan in these cases instead of an installment plan with the IRS.
Like a credit card, paying back a personal loan will significantly impact a person’s credit score. Making late payments (or failing to pay at all) can severely impact a FICO Score. The taxpayer will also see their credit score drop due to a new hard inquiry. Fortunately, the negative impact of hard inquiries tends to dissipate after a few months.
Delinquency & Liens
When someone doesn’t pay their taxes, the IRS has the right to place a tax lien on the taxpayer’s property. What is a tax lien? A Federal Tax Lien is a claim by the IRS against a delinquent taxpayer’s assets or property. The lien protects the government’s interest in all the taxpayer’s property, including real estate, personal property, and financial assets.
Fortunately, tax liens have not been part of credit reporting since 2018. Before 2018, active liens were regularly reported by Experian, Equifax, and TransUnion – the three major credit reporting bureaus. This means a tax lien won’t be visible on your credit report.
Unfortunately, future lenders can still see tax liens through public records, meaning that these liens can harm future credit applications – making getting new credit cards, personal or auto loans, or mortgages much more difficult.
For more U.S. state and federal taxpayers, the tax season will have no impact on their credit score. Most Americans receive tax refunds, while others are required to repay reasonably small amounts in back taxes.
Those with significant tax bills may struggle to repay what they owe. Fortunately, the IRS offers repayment plans via installment payments. These plans typically run for 120 days (three months), but the IRS might be willing to tailor a specialized program based on everyone’s unique tax situation.
Others may turn to credit cards or personal loans to settle back taxes. It is here where the trouble may arise. Failing to repay loans and credit cards can significantly impact a person’s credit score. Equally impactful is the taking on large amounts of tax debt – raising credit utilization. These two factors make up 65% of a FICO Score, meaning they can destroy your credit score for years to come.
Ultimately, however, there are plenty of ways to tackle tax debt effectively – and comfortably. Always make sure you talk to a tax expert when filing and consult with them (and the IRS) regarding repayment plans. Doing this is will significantly ease the stress – and credit scorn damage – on April 15 and after
Related Article: Smart Ways To Manage Your Credit Card
Featured photo by Sarah Pflug / Burst
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