Debt settlement seems like an attractive, and perfectly sensible, alternative to filing bankruptcy for many potential bankruptcy clients, and for some that could be the case. However, it’s usually the individuals that have the funds available to settle their debt that are typically the ones that stand to incur the most serious tax consequences as a result of the settled debt.
For example, if you have $50,000.00 in credit card debt and a retirement fund from which you could draw on to settle the debt, withdrawing $25,000.00 to settle the debt may seem like a perfectly reasonable use of the funds. In practice, though you will most likely create additional financial problems as a result of the settlement.
The first issue is the actual withdrawal of the funds from your retirement account. Let us assume that there would be tax consequences for such a withdrawal, either tax on the fund itself, or taxes and penalties for early withdrawal, or both. In either case, the withdrawal itself could lead to unexpected, unnecessary, and unpleasant tax consequences.
The second issue is the settlement itself. What the creditors, and especially the third party agencies, may not tell you is that debt settlement will lead to taxable income. Forgiveness of indebtedness is considered taxable income.
For instance, if you settle a $50,000.00 debt for $25,000.00, you will receive a 1099 from the lender for $25,000.00 of taxable income. This means that you will have to pay taxes on an additional $25,000.00 of income that you had not planned for, or paid any estimated taxes on, during the course of the year.
Of course this is not to say that debt settlement may not be the preferred option, depending on the whether there are other issues that would be problematic in a bankruptcy filing, and/or your tax bracket. It is certainly very important to consider the tax consequences prior to engaging in debt settlement.
Lastly, the other important aspect worth noting is that the debt most likely could have been discharged without tax consequences in a bankruptcy, but now the tax liabilities that you have created are not going to be discharged in a bankruptcy filing (for a period of time). And, the funds you used to settle the debt from your retirement account would most likely have been protected from the creditors in a bankruptcy filing.
If you are currently struggling to pay your debt and are considering debt settlement, please reach out to Minnesota’s nicest bankruptcy law firm at LifeBackLaw.com for a free consultation first to see if there is a better way. We look forward to hearing from you and helping you get rid of debt and get your life back!