What Happens to Tax Refunds in Bankruptcy?

Some individuals filing for Chapter 7 or 13 bankruptcy will be able to protect a tax refund—but not all. Whether you can keep your return will depend on the laws of your state and the prebankruptcy precautions you take to protect your refund.

Tax Refund Assets in Bankruptcy

A tax refund is an asset in both Chapter 7 and Chapter 13 bankruptcy. It doesn't matter whether you've already received the return or expect to receive it later in the year. If you still have it in your bank account, if it's being processed, or if you'll get it once you file, it's an asset. You can expect the appointed bankruptcy trustee to ask you whether you've received or expect to receive a return.

As with all assets, when you file for bankruptcy, you can keep your return if you can protect it with a bankruptcy exemption. Each state decides the type and amount of the property you can exempt, and so protections vary widely. As a rule, a tax refund isn't always easy to protect. Most states don't have a specific tax refund exemption.

However, you might have a wildcard exemption available to you. The wildcard exemption protects any asset of your choice. Also, your state might allow you to choose between the state and federal exemption systems. The federal wildcard exemption is usually larger than that of the state. Find out the current amount of the federal wildcard exemption.

Planning for Chapter 7

Here are some ways to increase your chances 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 use 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.

These strategies have been found to pass muster in most bankruptcy cases because you're allowed to use your assets to pay expected living expenses. Neither option involves an attempt to avoid paying a creditor, which is considered fraudulent in bankruptcy.

Adjust withholdings. If you expect a significant return because of amounts deducted from your paycheck, the fix is to adjust your tax withholding early in the year. Keep in mind that this tip won't be as helpful if you change your withholding later in the year such as from October through December.

Contribute to retirement. You might want to defer more of your salary into an employer IRA or 401k. However, depositing the tax refund into your bank account before making a retirement fund contribution won't work. Once the return hits your account, it will become an asset.

Tax Refunds in Chapter 13 Bankruptcy

When you initially file for Chapter 13, you'll need to protect your tax refund with an exemption to keep it, or use it for necessary expenses before filing, as discussed above. If you can't, you'll pay it to your creditors.

During your three- to five-year repayment plan, it works a bit differently. You're required to contribute all disposable income to your Chapter 13 plan. If your plan pays less than 100% to creditors, the trustee can keep your tax refund. It won't reduce your plan payment, however. Your creditors will receive the percentage of your total disposable income, which will include your tax return, that they're entitled to under your plan.

Possible Ways to Keep a Tax Refund in Chapter 13

Determining what to do with your tax refund is mainly discretionary, so your trustee might allow you to keep the tax refund. An unforeseen event or need that has affected your ability to pay living expenses might sway the trustee. For instance, it's common for a debtor to need car repairs or a new vehicle at some point during the plan.

Even so, in most cases, the trustee will require you to contribute your tax refund as part of your Chapter 13 plan. As a practical matter, one of the only available preventive options in Chapter 13 is to adjust your employment tax withholding to decrease your tax refund. The smaller your refund, the less the trustee can take. But it's best to do this before filing for Chapter 13. You wouldn't want it to later appear as an attempt to hide bankruptcy income owed to your creditors.