It’s best to pay off your debt to the IRS first

It’s a good thing in this economy to have some extra money on hand.

But what do you do with it? That’s what many people wanted to know during a recent online discussion. Here’s what I suggested:

Question: My husband has received a small work bonus and we are wondering about the best wa

y to use the money. Based on a withholding flub, we will owe around $2,700 in federal taxes this year. We are also trying to pay off high-interest credit card debt, and build up our emergency fund. I think we should put $1,000 in our emergency fund, use the rest to pay off the credit cards and get on a payment plan with the IRS. My husband thinks we should pay the IRS immediately, and divide the rest between family obligations and paying a smaller amount on the credit card debt but nothing toward our savings. What do you think?

Answer: If you owe $25,000 or less in combined tax, penalties and interest, you can request an installment agreement using the Online Payment Agreement application at www.irs.gov or complete IRS Form 9465 “Installment Agreement Request.” But be aware that your balance is subject to daily compound interest and a monthly late payment penalty. The penalties and interest continue to be charged on the unpaid debt for the length of the installment agreement.

But even if the interest on the tax debt is lower than what you’re paying on the credit card debt, think about this: What if your finances deteriorate while under the installment agreement and you can’t pay the tax debt? The IRS has considerable collection powers compared to credit card companies.

Pay the IRS first. After that, put a small amount of the money into an emergency fund. If you don’t have some savings and an unplanned expense comes up, you’ll likely resort to credit again. Use the remaining bonus money to pay down the credit cards.

Q: We paid off $20,000 in credit card debt over two years. What should we do with the money we were directing toward our credit cards? We have $15,000 in savings. We owe about $75,000 on our student loans. I’m hesitant to pay off the student loans since the interest rates are so low. We feel it’s mostly free money and our incomes are still within the bracket where the interest is fully tax-deductible.

A: The federal tax deduction for student loan interest — a maximum of $2,500 — is nice. For tax year 2010, the deduction is phased out for single filers and heads of household with modified adjusted gross incomes between $60,000 and $75,000; for married taxpayers, it’s between $120,000 and $150,000.

Even with the tax break, your student loans are not free money. If you have a disruption in your income, you may not be able to make your monthly payments. A tax deduction won’t help you in that event. While you have the money, pay off as much of the student loans as possible. Trust me, there are a lot of people who are unemployed right now who wish they hadn’t hesitated to get rid of their loans when they had the means.

Q: I will be getting a small raise this year. I have about $30,000 in student loans, about $5,000 in credit card debt, and not much in the way of liquid savings. I am also trying to save for potential unpaid maternity leave sometime in the next couple of years. Any advice?

A: Save something in an emergency fund. Aim for at least one month of living expenses to start. Once you have a cash cushion, tackle the debt like Ray Lewis going after a quarterback. After the debt is gone, save at least three to six months of expenses, which should help during your maternity leave. Try hard to get rid of as much of that debt before you have a baby.

Q: I am a 26-year-old grad student. I am paying for school ($20,000 a year in tuition) out of pocket and have a good job. I have a modest emergency fund. I am not saving for retirement. Many people disagree with my decision. I will be done with school in two years, and I would be able to start saving then. Is it OK to wait a little while to save for retirement?

A: As long as you have some savings in case of an emergency, you are doing the right thing paying for college so you don’t accumulate student loans. When you’re done with school, you’ll have more money to put toward retirement.

Washington Post Writers Group