(If you missed Bankruptcy vs. Debt Settlement Part 1, please check out that blog entry first.) Our last installment described a likely scenario in which “John” would offer $4,000 to ABC Bank to settle a credit card debt of $10,000. This seems like a great deal, right? Maybe, but there are a lot of hidden issues that one needs to be aware of when settling debt in this manner.
Problems with Debt Settlement
The first issue is that the banks will generally not take payments on the offer they have made or accepted. They want their money now! So, John will probably have to have the $4,000 paid to the bank within a day or two of this agreement.
Second, and this is extremely important, the $6,000 that John will be “saving” is now taxable as income to him by the IRS. Yes, ABC Bank is going to send a “1099 Debt Forgiveness” form to the IRS for $6,000 and at the end of the year John is going to be hit with a tax bill from the IRS as having $6,000 in income that he never paid taxes on. This can get really ugly, especially if you are settling large amounts of debt!
Finally, many individuals will get these lump sums to settle the debt from their retirement accounts such as a 401k or an IRA. Again, there can be some pretty major tax consequences to taking money from a 401K or an IRA especially if you are below the requisite retirement age.
By the Numbers
So, with that in mind, let’s take John’s situation and put some estimated numbers on this settlement proposal and see what it looks like. John has offered to settle his $10,000 credit card debt with Bank ABC for $4,000. After consideration, ABC Bank has accepted his offer but they it in a lump sum want the cash within one week. John doesn’t have $4,000 on hand and must withdraw it from his IRA.
John is only 45 years old, so he has to pay a 10% penalty for an early withdrawal. He also is in the 15% tax bracket for tax purposes to he has to account for that when he withdraws the money. What this means is that in order to get his hands on $4,000 to use for payment to ABC Bank, he actually needs to take about $5,300 and send $1,300 of that to the IRS for the 10% penalty and 15% income tax. So, now John has his $4,000 (which he spent an additional $1,300 to get) and he pays it to ABC Bank.
Unfortunately, at the beginning of the next year, he receives a 1099 Debt Forgiveness form from the IRS in the amount of $6,000. Now, when John does his taxes, he must pay income taxes on that $6,000. Remember that John pays income taxes to the IRS at a rate of 15%, so he must pay in an additional $900 to the IRS than he otherwise would have had to pay.
Credit Score Impact
All in all, John paid $6,200 in lump sums to settle the $10,000 debt that he had with ABC Bank. Still not a bad deal, but wait... it doesn’t end there. The next time John checks his credit report he is going to see an entry by ABC Bank that says something along the lines of “debt settled for less than what was owed."
This is going to drive down John’s credit score significantly and will stay on his report for seven years. According to lenders that I have spoken with, having a settled debt on a credit report is almost as bad as having a bankruptcy reported to the credit bureaus and in some instances it is even worse.
As you can see, a lump sum settlement isn’t always as cut and dry a solution to an outstanding debt as it may seem. If you find yourself in a situation similar to John's, give us a call and see how we can help. Bankruptcy could be the answer. Steidl & Steinberg has over 30 years of experience in helping people solve their debt problems.