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Taxes and Your Credit Score: How Mistakes Can Prove Costly

Apr 14th 2016
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Over the last decade or so, most consumers have learned a lot about what impacts their credit score, and why it's important to have a good credit rating. As a result, many people have made changes to try to help get those numbers up. They have closed unused credit cards, been more vigilant to fraud, and made extra efforts to get payments in on time.

What many of them haven't done is pay attention to their tax situation. As a rule, they are filing and paying by April 15th, but they aren't necessarily paying attention to things like tax liens, at least not in terms of how taxes impact their credit score.

But they should. A bad score is bad no matter why it's bad, so in addition to the usual issues of payment timeliness, total debt, and so forth, consumers should be very attentive to tax issues. Here are the main areas where they should watch closely:

Income Taxes

As mentioned earlier, most people are very alert to that April 15th deadline each year. They are aware of the penalties and fines that can accompany a tardy return or other tax filing errors.

But it's important to stay compliant on income taxes for reasons other than appeasing the Internal Revenue Service. Late or unfiled tax returns can erode your credit rating, for a couple of good reasons.

First, no one will want to loan you money if you are irresponsible paying the one bill that every working American must pay every year. If you won't pay your taxes, why would they expect you to pay a credit card on time? And second, shirking your tax obligations can ultimately generate wage garnishment, which is essentially a reduction in your income. Because your income figures into your credit worthiness, it is bad to see it reduced.

Property Taxes

The credit bureaus aren't just keeping in touch with the federal government. Poor taxpaying habits at the local level can hurt you, too.

Tax liens are filed against property for which the property taxes go unpaid. These bills must be satisfied before the property can be transferred to a new owner. In addition, individuals or companies can purchase the lien against a property, and they could ultimately force a sale to satisfy the liens. These buyers can also force the owner to pay interest and legal fees.

As a result, the tax liens quickly balloon to an amount much larger than the initial debt. For this reason, tax liens are a serious negative mark on your credit report. Most local governments have some provision for payment plans; if you are unable to pay by the due date, consult with them about this option.

Methods Of Paying Taxes

As a rule, it's best to pay your taxes in whatever way you have to. But if you owe on property taxes, income taxes, or vehicle taxes, paying with a credit card could have at least some negative impact on your score.

Remember that a key component of credit score is the total amount of debt. Popping an extra $2,000 or $3,000 onto a credit card--especially when it's for something you knew would be coming due--is good only in that it keeps you compliant with the law. Ultimately, it can be bad for your credit.

This doesn't mean that paying with a credit card is inherently bad, but if that balance isn't immediately paid off and it becomes revolving debt, there's an obvious impact.

Taxes and credit scores are both important components of our financial lives. It's very important that we do our best in both areas, and that we don't sabotage one while satisfying the other. As is always the case with taxes, plan ahead so that deadlines don't put you in a problematic position. You'll end earning a better credit rating while still staying on the good side of your government.

Editor’s note: For more insight on federal tax liens and tax levies, check out this article from Craig Smalley, EA.

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