What Happens to Tax Refunds in Bankruptcy?
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If you file for Chapter 7 or Chapter 13 bankruptcy, will you lose your tax refund? The answer: it depends. Most individuals filing for Chapter 7 bankruptcy are able to protect their tax refunds. For Chapter 13 debtors, this protection is less likely. Whether the bankruptcy trustee can take your tax refund check depends on the type of bankruptcy you file for, the timing of your filing, and the precautions you take to protect your refund.
Tax Refunds as Assets in Chapter 7 Bankruptcy
When you file for bankruptcy, your tax refund, whether already received or expected for that year, is considered an asset. As with all assets, if your tax refund is “exempt” the bankruptcy trustee cannot take it. Since the allowable exemption amounts for various assets vary from state to state, the amount of your tax refund that you can exempt depends on your state. If your state does not have a specific exemption for tax refunds, you may be able to use the wildcard exemption, which can be used to protect any asset.
Planning Ahead in Chapter 7
With some careful planning, you have a better chance of keeping your tax refund in Chapter 7 bankruptcy.
If you file during tax season. Individuals who file bankruptcy during tax season often have to figure out what to do with the tax refund they have just received. You can use any available tax refund or wildcard exemption to protect it. But if your state doesn’t offer these exemptions, or you want to save your wildcard for other assets, consider these strategies:
- If possible, file for bankruptcy after receiving and spending your tax refund. If you choose to do this, be sure to spend your refund on necessities (living expenses such as your mortgage, medical expenses, clothing, or food) and not to purchase new assets.
- Use your tax refund to pay your bankruptcy attorney for the fees and costs of your case.
Using these strategies, you will have no assets left from your tax refund to list on
your bankruptcy petition.
If you file later in the year. Filing for bankruptcy in the last quarter of the year (October through December) can be problematic if you are expecting a large tax refund. If you expect a large refund because of large withholdings from your paycheck, you can adjust your tax withholding to a lower amount so that you don’t get a tax refund.
Another way to protect a tax refund is to defer more of your salary into an employer IRA or 401k. However, do not deposit the tax refund into your bank account and then make a retirement fund contribution, as that will make the refund an asset.
Tax Refunds in Chapter 13 Bankruptcy
In Chapter 13, your tax refunds will be scrutinized by the trustee during the life of the plan, which may last either three or five years. If you are in a plan that pays less than 100% of your debt back to creditors, the trustee has the discretion to keep your tax refund during the life of the plan. Since Chapter 13 requires that all disposable income be paid into the plan, most trustees classify tax refunds as disposable income.
Unfortunately, the tax refund paid into the plan does not reduce your plan payment because the tax refund is merely additional disposable income. This means that your refund checks during your Chapter 13 plan give creditors an additional percentage of repayment.
Possible Ways to Keep Tax Refunds in Chapter 13
Since determining what to do with your tax refund is largely discretionary, your trustee may allow you to keep the tax refund in special circumstances (for example, if you can demonstrate an unforeseen circumstance or need that has affected your ability to pay living expenses). However, in most cases, the trustee will require you to contribute your tax refund as part of your Chapter 13 plan.
One of the only available preventive options in Chapter 13 is to adjust your employment tax withholding to decrease your tax refund. The less your refund, the less your trustee can take.Source: www.alllaw.com