How Much Tax do You Pay on Canceled Debt?

By Sally

Dear To Her Credit,

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How much tax will I pay on a $957 debt that a credit card canceled? They did send me a 1099-C Cancellation of Debt form. Please advise. Thank you.  

- Cynthia

Dear Cynthia,

The amount of federal income tax on $957 depends on many factors. If I were to hazard a guess, it would be about $240. That assumes you are in the 25% tax bracket -- in other words, you pay 25% of every additional dollar of income on your return.

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If your income after deductions is less than about $35,000 (about $70,000 if you are married and you file jointly) you may be in the 15% tax bracket. In that case, an additional $957 will only cost you about $144 in income tax.

It's never going to be exact. Many credits and deductions have limits and phase-out ranges that depend on your adjusted gross income. An additional $957 in income can set off a complicated chain of tax events. Perhaps the best way to determine how much it would affect you is to use tax software. You can find online software that doesn't take your credit card until you're ready to file -- if at all. I highly recommend letting the software do the hard work for you.

Your state income tax is generally calculated starting with your federal income tax return amounts, so don't forget to allow for an increase in state tax, too.

Most Americans expect a refund check every year. The average refund for the 2011 tax year was almost $3,000. If you're one of those who expect a refund every year, you may hardly notice a difference of $144 to $240 in your tax bill. If you usually cut it closer, however, you may want to plan ahead.

You can change your withholding amount to have a little more taken out every month. Print out a new Form W-4, fill it out and take it to your payroll department. If you don't know how to fill it out, ask an accountant. I don't find the Internal Revenue Service worksheet that comes with Form W-4 to be terribly helpful.

I've had better luck with the IRS Withholding Calculator. If you have your most recent pay stub handy, you can use this online calculator to quickly estimate the best way to fill out your Form W-4 and have the right amount of tax withheld for the rest of the year.

Another way to take care of that tax bill now is to simply send it in. Write a check to the IRS with your Social Security number on the check. Print out a voucher from the IRS website and send it with the check to the address in the instructions. You do not need to fill out the estimated tax worksheets.

I do not recommend paying the IRS with your online banking bill pay system. It's too easy for the payment to be misapplied. Paying by credit card isn't perfect, either, because you'll get hit by extra fees from your bank. If you want to pay the IRS online, use the Electronic Federal Tax Payment System on the IRS website.

Even if you don't get a refund next year or if you have to pay something, you're not likely to owe interest and penalties. The IRS does not impose penalties for underpayment of tax unless you owe $1,000 or more when you file your return.