A tax refund is a valuable asset, and you'll likely want to keep as much of it as possible when filing for bankruptcy. But because your creditors also want it, the trustee appointed to your case will ask whether you're expecting a tax refund at the 341 meeting of creditors, the hearing all filers must attend.
Unfortunately, preserving a tax refund in bankruptcy isn't easy. Not only will maximizing your refund take careful planning, but it also will depend on:
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If you're planning on filing for bankruptcy and want to protect a tax refund, here are three approaches to consider:
Keep reading for details about each strategy.
Ensuring you aren't owed a tax refund at the end of the year is the best way to avoid having a refund the trustee appointed to your case can take. Here's why.
You're essentially setting up a savings account if you pay more in taxes than needed each month. The problem? Protecting any cash or money you're entitled to receive when filing for bankruptcy is difficult. You'd need to either spend it before filing or be able to protect it with a bankruptcy exemption, and doing so isn't always possible.
If you receive your refund before you file for bankruptcy, consider spending it before filing. But be sure to keep track of your expenditures and use the funds for necessary expenses, such as:
You don't want to pay bills in advance, and you'll want to avoid paying a significant amount to a family member, friend, or a particular creditor because the Chapter 7 trustee appointed to oversee your case could try to get the money back. Learn about preference payments and the clawback provision.
You lose property you can't exempt in Chapter 7 bankruptcy. If you can't adjust your withholdings or spend your return before bankruptcy, check whether your state offers a bankruptcy exemption you can use to protect your refund. But don't be surprised if your state doesn't provide one because most states don't have an exemption for a tax refund.
Instead, look for a wildcard exemption. A wildcard exemption lets you protect any property of your choice within limits set by the state. Also, an earned income credit exemption or a cash exemption might work, although you won't be able to preserve much cash in most states.
Here's a simplified explanation of how the above strategies work in Chapter 7 bankruptcy.
Learn more about keeping your property in bankruptcy.
The strategies discussed above will apply to tax refunds in Chapter 13 as well. However, if you aren't able to protect the funds, you won't turn them over to the trustee. Instead, you'd pay nonexempt funds through the Chapter 13 plan.
Also, an additional wrinkle exists because a Chapter 13 case takes three to five years to finish.
Chapter 13 files pay all disposable income to creditors through a Chapter 13 repayment plan. A potential income tax return you didn't exempt when you filed could be problematic if your Chapter 13 trustee argues it's extra disposable income and expects you to hand it over for creditor payment.
To avoid this problem, consider adjusting your withholding to minimize your refund before filing your bankruptcy case. Otherwise, your bankruptcy lawyer will be in the best position to explain the Chapter 13 practices in your local court.
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