A friend of mine has her deductions set at nine, so very little tax is taken out of her check. She uses the cash to pay off her high-interest rate credit cards. At the end of the year she may owe $6,000, but at an interest rate much lower than her credit cards. Does this seem like a smart strategy?
The scheme (and I use that word purposely) sounds extremely risky. It is not something that I would ever recommend.
First, claiming nine exemptions can sometimes raise a red flag with the IRS. Second, you say that at the end of the year she may owe $6,000, but at a lower interest rate than her credit cards. How does she plan to pay the $6,000? Set up a payment plan with the IRS? Just to set that up costs $105, and the balance due incurs interest and penalty until paid at roughly 13 percent per year. Also, if you miss a payment, the IRS will immediately clamp down on you. You never want to owe the IRS if you can help it. If she can pay off the entire tax amount at the end of the year, why doesn’t she just use that money to pay off her credit cards?
You also say that she uses the extra cash to pay off her credit cards, but that takes a lot of discipline. What happens if she has an unexpected expense one month, and she uses that money for the expense? Then she will owe the credit card companies and the IRS. It would be much better if she could get a loan from a bank or credit union and pay off the credit cards. There are also ways to pay down credit card debt slowly but surely by eliminating the balance on one card at a time. The key there is to stop using the credit cards and live within your means. What she is doing is the worst possible strategy in my opinion.
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Answered by: David A. Caplan, CPA, is a sole practitioner in Lafayette Hill, Pa.