What Happens to Your Tax Refund in Bankruptcy
In A Nutshell
Tax Refund Received Prior To Bankruptcy
You keep the “exempt” amount. The Trustee takes the “unexempt” amount.
Talk to an attorney prior to depleting the refund.
Tax Refund Received During Bankruptcy
Chapter 7 – You keep the “exempt” amount. The Trustee takes the “unexempt” amount.
Chapter 13 – Trustee may take the “unexempt” amount. You use it to supplement your income.
In More Detail
One of the number one questions I get asked when discussing bankruptcy with potential clients is, “If I file bankruptcy, will I be able to keep my tax refund?” This question, although it may highlight the problem that many people face, is a good one to ask if you typically receive a refund.
For many, a tax refund is a way to “catch up” their delinquent debt payments. It is a way for them to “make right” the “falling behind” they have experienced exacerbated by the holiday season. Many count on their refund to supplement their income…to allow them to afford their bills.
First, I want to encourage you to change this philosophy regarding tax refunds.
Let me explain why you receive a tax refund. Each paycheck you receive, money is withheld by your employer to send to the IRS on your behalf. This money is accredited to your taxes that become owed by April 15 of the following year. The amount of tax you pay is dependent on the tax bracket within which you fall. When you began your employment you selected the amount of tax to be withheld from each paycheck to pay towards your taxes. If you overestimate the amount needed to be withheld, then you will receive a refund when your tax return is filed. Note: there can certainly be other reasons for receiving a tax refund: (1) you have a child tax credit that you did not previously have, (2) the tax code changes, (3) you have not updated your filing status (i.e. single, joint, head of household, etc.)…and more.
The more money withheld by your employer, the more tax refund you will receive. The less money withheld by your employer, the more money you will have in your pocket each paycheck. You will have a better chance of affording your bills during the year if you were to receive more money each paycheck.
Second, let me explain what happens to your tax refund in a bankruptcy. There are 2 scenarios to consider: (1) receiving your tax refund prior to filing bankruptcy, and (2) receiving your refund during your bankruptcy.
Tax Refund Received Prior To Filing Bankruptcy. Let’s talk about receiving your tax refund prior to filing bankruptcy. If this is the case, then consulting an attorney will be of utmost importance. When filing a bankruptcy the court is concerned with the value of property that you own (i.e. exemptions – find more about exemptions here). If the value of your property exceeds the exemption limits, then the Bankruptcy Trustee could take the items from you and use them to pay off some of your debt. Therefore, if the value of your tax refund exceeds the exemptable limits available in your situation, then the Bankruptcy Trustee could take the unexempt portion.
An example helps explain this: You receive a $9,000 tax refund on April 15 and decide to file a Chapter 7 bankruptcy on April 16. You are single and file the bankruptcy by yourself. The “wildcard” exemption allows you to exempt $5,000 of your tax refund. The remaining $4,000 (unexempt portion) of your refund must be paid into your case… you will lose this $4,000.
Talking to an attorney prior to filing your bankruptcy is important in this situation. There may be ways that you can delay the filing of your bankruptcy while legally (and non-fraudulently) depleting the tax refund. You do not want to attempt to deplete your refund without the assistance of an attorney as this could lead to consequences in your case. (Read this prior blog about things you should not do prior to filing bankruptcy.)
Tax Refund Received During A Bankruptcy. Receiving a tax refund during a bankruptcy may have implications on your case. It will depend on the type of bankruptcy that you file (Chapter 7 or Chapter 13) and your overall situation.
Receiving a tax refund during a Chapter 7 will affect your case the same as if you had received the refund prior to your case being filed. As stated above, if the value of your tax refund exceeds the exemptable limits available, then the Chapter 7 Bankruptcy Trustee can take the unexempt portion of the refund.
Receiving a tax refund during a Chapter 13 will act a little different. First, it depends on the amount of refund you receive. If the amount is “small” (i.e. less than $5,000), then you will likely keep the refunds received during your case. You will use the refunds to supplement your income. If the amount of your refund is “big” (i.e. greater than $5,000), then the Chapter 13 Trustee could require you to pay it (or a portion of it) into your Chapter 13 plan. Most of my clients do not have to do the latter.
If you are considering filing a bankruptcy and expect a tax refund, then I recommend that you speak with an attorney. You can begin this process with me at no cost by completing the online intake form. Or, you can skip the online intake form and set up a free consultation with me. This consultation can be done in my office, over the phone, or virtually through Facetime, Zoom, Google Meet, or Skype.