At a Glance
Using your tax return to pay off debt is certainly an option, but is it the right choice for you? The answer depends on your personal circumstances. In some cases, immediate living expenses need to take precedence. In others, getting out of debt is a top priority. If that’s your situation, it’s OK to use your tax return to start the process.
You don’t need to know a lot about taxes to use a tax refund for debt reduction. That said, having at least some knowledge of how the system works could help you increase the size of that return. That discussion, of course, should happen long before you start thinking about the best things to do with your tax return. But here are some things to know before you use your tax refund to pay off debt.
Using your tax refund to pay off debt
One of the strongest arguments for using a tax refund to pay off debt is that fewer monthly payments will lower your overhead and help you keep or save more of your paycheck. Granted, you’re giving up a lump sum of cash to achieve that goal, but it’s worth it if you don’t absolutely need the tax refund right now. If this is your situation, follow the steps below:
- Figure out which debt costs the most: Unless you took out a debt consolidation loan, you may be paying up to 25% interest on outstanding credit card balances. Look up the APR on each of your debt accounts to find your most expensive debt.
- Select a debt payoff method: Paying your debt accounts in order, starting with the highest interest rate first, is known as the debt avalanche method. Another method, called debt snowball, prioritizes balances from smallest to largest.
- Use your tax return to pay off what you can: Paying off the highest interest account might save you a few dollars, but does it significantly lower your overall monthly payments? Your payoff method should be based on the answer to this question.
- Create a budget for the new tax year: Once you’ve eliminated some debt, the numbers on your budget will change. Hopefully, you will have gained some relief by lowering the amounts you pay out each month. You can put the extra into your emergency fund.
Alternatives to paying off credit card debt with tax refund
If you’re seriously behind on your credit cards, another potential use for your tax refund might be a debt settlement offer. That tax check (or direct deposit) is for a limited amount of money, perhaps less than what you owe in debt. Call your credit card company and ask if they’ll settle your debt for less than the total amount owed. This is also known as debt forgiveness.
Frequently asked questions on using your tax refund to pay off debt
Does debt affect your tax return?
Personal debt, like credit cards and unpaid loans, does not affect your tax return, but the IRS is able to seize your refund if you owe federal or state taxes, child support, or student loan debt.
Is paying off credit card debt tax deductible?
Credit card debt and credit card interest are not tax deductible, but you may be able to deduct mortgage interest up to a certain amount if you qualify.
What is a debt tax?
Debt tax is a term used to describe taxes due on debt that has been charged off by your creditors. This is common in settlements and uncollectable debt.
Best things to do with your tax refund
If you’re not going to pay off debt, you could deposit your tax refund check into your savings or retirement fund, invest in the stock market, or pay for a college class or two.
Can debt collectors take your tax refund?
Your tax refund can be seized in whole or in part by the IRS if you owe federal or state taxes, child support, or student loan debt. It cannot be seized by private collection agencies.
How can I pay off my IRS debt?
You can call and set up a monthly payment plan with the IRS. Payments can be made by direct debit from your bank account or online through the Electronic Federal Tax Payment System ® (EFTPS®).
Can I write off credit card debt on my taxes?
Individuals cannot claim credit card debt or interest payments on their taxes. Businesses can claim credit card debt if the expenses are business related.
What kind of debt can be cleared from tax refund?
It’s your money, so you can clear any type of debt you want to. This includes credit card debt, loans, mortgages, personal lines of credit, and student loans.