Will the Bankruptcy Court Take My Tax Refund?

A tax refund is a valuable asset to both and your bankruptcy creditors—and you'll likely want to keep as much of it as possible. Maximizing your portion in bankruptcy takes careful planning and will depend on the bankruptcy chapter you file, the timing of your filing, and the state in which you live.

Tax Refunds in Bankruptcy

You receive a tax refund when you've paid more than you needed to pay in taxes. Although it might be nice to get a significant return at the end of the year, you might not be so happy about your savings plan if you find yourself filing for bankruptcy. Why? Because instead of using that money for your expenses, you might end up turning it over to your creditors.

Protecting a Tax Refund in Chapter 7 Bankruptcy

It isn't easy to preserve a tax refund in Chapter 7 bankruptcy. Here are your options.

• Using exemptions. Each state has a list of the property its residents can protect, or “exempt.” Some states allow residents to choose between two lists: state exemptions and federal bankruptcy exemptions. However, most states don't have an exemption that protects a tax refund. Instead, you might be able to protect some or all of it using an earned income credit exemption, a wildcard exemption (that allows you to protect any property of your choosing), or a cash exemption (not many states have cash exemptions). You'll lose any portion that you can't exempt.
• Planning. If you routinely received large tax refunds in the past, and expect to do so again, consider adjusting your withholding so that less is taken out of your paycheck. Doing so will minimize the amount of your refund. The smaller the refund, the less likely that a trustee will be interested in taking it, and the less that you have to try to exempt.

Another approach is to spend your refund before you file your bankruptcy case. A good practice is to keep track of your expenditures and to use the funds for necessary expenses, such as:

• rent or mortgage payments
• utilities
• food
• clothing
• medical expenses (including glasses and contacts, braces and dentures)
• car payments, maintenance, and repairs
• education expenses, and
• attorney's fees and costs for your bankruptcy filing.

You'll want to avoid paying money to a family member or friend because the trustee could try to get the money back. The same applies to paying a significant sum to a creditor, such as for a credit card balance. Again, you'll want to make sure to keep good records, including receipts, documenting how you spent the money.

Tax Refunds in Chapter 13 Bankruptcy

The bankruptcy code requires that you pay all disposable income received during a Chapter 13 bankruptcy into the plan. Most Chapter 13 trustees treat a tax refund received during your case as extra disposable income. Therefore, you'll likely want to adjust your withholding before you file your case to minimize your refund.

It's important to remember that everyone's situation is different. Because another approach might be best for you, a prudent approach is to consult with a knowledgeable bankruptcy lawyer.