Consumer Comeback Blog

How to Avoid a Credit Score Drop from Your Taxes

Written by Jeffrey Trull

credit-score-taxesIf you can’t pay your taxes, the IRS might not be your only problem. While taxes and credit often don’t overlap, the potential is there for the former to affect the latter. Unfortunately, it’s usually bad news when this happens, and some common tax issues can cause a massive drop in your credit score.

Here are different ways taxes impact your credit score and how to avoid them.

Taking on debt to pay taxes

If you’re surprised by taxes owed and suddenly need to pay, you may need to come up with cash quickly.

If you don’t have the cash to pay, the IRS does allow you to pay your tax bill with a credit card. You’ll be subject to fees of 1.88%-2.35% when you do. Of course, regular credit card fees and interest charges apply, too.

Presumably, this plan means taking on credit card debt, which can hurt your score if your utilization rate suddenly shoots up.

Get your taxes done as early as possible to avoid this problem. Procrastinating will only make the situation harder and give you less time to plan.

If you can’t pay with cash, consider applying for a repayment plan with the IRS. You’re likely to be approved automatically if you owe less than $50,000 in taxes, and these agreements won’t appear on your credit report unless a tax lien is filed.

Refund anticipation loans

With “loan” in the name, you should already be wary of this tax-related scheme. “Refund anticipation loans,” which also go by other names, are when you take an advance on your tax refund and agree to pay back this loan once your check comes from the IRS.

According to CNNMoney, the fees and interest rates on these loans are very high. One example of these loans costs a one-time fee of $49 plus interest, which could be around 36% APR.

You may get burned if your refund takes longer than anticipated or is less than expected. If you can’t pay off this loan, it will be reported to the credit bureaus and damage your credit score.

While you may be eager to get your refund, why take a loan and pay fees? Instead, just wait for your return to come in. If you e-file and request direct deposit, the IRS should send your refund within three weeks. Mine came in about one week after filing this year, so there’s little excuse for not waiting.

Identity theft

Tax scams are a big problem. Yahoo! News reports that investigations into scams by the IRS tripled in 2012 and are expected to double again this year.

Identity thieves pretending to be the IRS may steal your Social Security number and other information. They can use this in a variety of ways to steal money from you or the IRS, including filing a fake return.

While identity theft of this kind doesn’t always affect credit, there’s always the potential if your Social Security number or information is used in other ways. It’s all about monitoring your credit report and watching out for any potential credit-related problems. If your identity has already been stolen, take steps to protect yourself like filing a fraud alert or credit freeze to thwart future attempts. You likely have much more on the line than just your tax refund.

Taxes owed and tax liens

Owing taxes can be the biggest problem for your credit score.

Leading the way are tax liens. Tax liens are used by the IRS when you owe taxes (particular large amounts) and don’t pay or take other action. Once this happens, the IRS places a lien on public record in an attempt to collect the debt.

This lien will end up on your credit report, and your score can drop by 200 points. Tax liens also stay on your credit report indefinitely if not paid, and for seven years if they’ve been settled.

The only good news is that a tax lien can be removed from your credit history thanks to new IRS regulations. Once it’s paid or on track for full payment with an installment plan, taxpayers can apply to have it withdrawn. According to John Ulzheimer on the blog, you may even be able to retroactively have liens removed from your credit report, which can give your credit score a big boost.

Beware: You may be out of luck with state taxes. According to Ulzheimer, this only applies to IRS liens, not state tax liens.

Typically, installment plans are not reported to credit bureaus. Apply for one of these plans rather than having a lien placed against you, and you’ll often avoid severe credit damage.

(photo credit: saturnism)