Credit card settlement is a debt-reduction strategy that involves negotiating the payoff of a credit card debt for less than what you owe. This strategy can be particularly effective if you have amassed more credit card debt than you can handle -- some lenders see settlement as an opportunity to avoid having you default on a credit card balance. Whether you can settle a credit card debt is at the discretion of your individual lender. Also, negotiating a credit card settlement may increase your tax liabilities.
Taxation Rate
The amount you save on credit card debt is taxable at the standard rate for your income bracket. This means that if your earnings put you in the 10 percent tax bracket, you will have to pay 10 percent of your savings in taxes as earned income. However, if you negotiate a large settlement -- for example, you settle a $50,000 credit card debt for $25,000, the $25,000 savings on your credit card debt may add enough income to place you in the next higher tax bracket. This means that you pay more taxes on both the forgiven debt amount and your income from wages and other sources.
Exception
The Internal Revenue Service provides a $600 exemption on settled credit card debt. If the settlement results in a savings of $600 or less, you will not have to pay taxes on the forgiven amount as earned income. If the savings results in earned income of more than $600, the first $600 of the forgiven amount is not subject to taxation. For example, if you negotiate settlement of a $5,000 debt for $3,000, you would only pay taxes on $1,400 of the forgiven amount as earned income.
Reporting
When you negotiate a settlement with your credit card company, the company will report the forgiven balance to the IRS. It will also send you a copy of form 1099-C showing the amount of debt canceled under the settlement. You must include the forgiven amount shown on form 1099-C as miscellaneous income on your tax return.
Considerations
After settling a debt for less than the full balance, the credit card company reports the debt as settled to credit bureaus, which can impact your credit score. The effect of debt settlement on your credit depends on your current credit history -- if recently missed debt payments have lowered your score, a settlement may have little negative impact on your creditworthiness. Because the amount of debt you carry also affects your credit, the reduction of debt under a credit card settlement may partially offset credit score damage caused by a settlement entry.
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