What Happens to Your Tax Refund in Bankruptcy?

You’re preparing to file bankruptcy and wondering about your tax refund. Will you still receive it? Can you keep it? These questions matter because your refund could be significant.

Here’s the good news: many Chapter 7 filers keep their full tax refunds. You can protect your refund through exemptions or by spending it on necessary expenses before filing.

Your refund’s fate depends on timing, exemptions, and how you use the funds. Understanding these factors helps you protect what’s rightfully yours.

How Bankruptcy Affects Your Tax Refund

Refunds for taxes on income you earned before filing bankruptcy become part of your bankruptcy estate. Whether you keep the refund depends on available exemptions and your bankruptcy chapter.

The key date is your filing date. Any refund based on income earned before that date belongs to your bankruptcy estate.

Understanding the Bankruptcy Estate

When you file bankruptcy, a legal entity called a bankruptcy estate is created. Your estate includes everything you own or are entitled to when filing.

Even if the IRS hasn’t issued your refund yet, you’re entitled to it. Bankruptcy law treats these future refunds as current assets because you overpaid your taxes.

Think of it like money in a bank account. The IRS is holding your money, and you’re entitled to get it back.

Can the Trustee Take Your Refund After Your Case Closes?

The trustee cannot take your refund after closing your bankruptcy case. However, trustees can keep cases open until you receive expected refunds.

Trustees do this when they expect a large enough refund to justify the effort. Many filers avoid this by spending refunds on necessities before filing or using exemptions for protection.

Protecting Your Refund With Exemptions

Exemptions are laws that protect certain property during bankruptcy. You can potentially protect all or part of your tax refund through exemptions.

Each state has its own exemption laws. Federal bankruptcy exemptions also exist. Some states let you choose between federal and state exemptions.

Whether your refund is protected depends on which exemptions apply in your case.

State Exemptions for Tax Refunds

Some states have specific exemptions protecting tax refunds or refundable tax credits. The Earned Income Tax Credit (EITC) and Child Tax Credit often have special protection.

If your state doesn’t specifically protect tax refunds, you might use a wildcard exemption. Wildcard exemptions protect property that doesn’t fall under specific categories.

Wildcard exemptions have dollar limits. Check your state’s exemption laws to see what’s available.

Federal Exemptions for Tax Refunds

Federal bankruptcy exemptions don’t specifically protect tax refunds. But they do offer a wildcard exemption.

You can protect property of your choice, including tax refunds, up to certain amounts. The federal wildcard exemption is currently $1,475 plus any unused homestead exemption, up to $13,950 total.

Many filers apply wildcard exemptions to tax refunds first. Trustees more easily take cash refunds than physical property to pay creditors.

How to Protect Your Refund Before Filing

Only the refund portion still in your possession on your filing date becomes part of your bankruptcy estate. Many filers take strategic steps before filing to protect their refunds.

You have two main options: spend the refund on necessary expenses or adjust your tax withholding.

Spend Your Refund on Necessary Expenses

Spending your tax refund on necessary expenses before filing removes it from your bankruptcy estate. The money is no longer there when you file.

Acceptable expenses include:

• Rent or mortgage payments
• Utilities
• Groceries
• Necessary home or car repairs
• Medical or dental bills
• Insurance payments
• Clothing or shoes you truly need

Avoid spending on luxuries like vacations, expensive jewelry, or gifts. These purchases raise red flags in your bankruptcy case.

Trustees closely review how you spend refunds. Focus on reasonable and necessary costs. Keep proof of all purchases.

Adjust Your Tax Withholding to Avoid Overpaying

If you’re planning to file bankruptcy within the next year, adjust your income tax withholding. You can reduce the likelihood of receiving a refund in the first place.

Adjust your withholding so you only pay the amount of taxes you actually owe. Your take-home pay increases throughout the year for covering living expenses.

Be careful not to underpay your taxes. You may owe money when filing your tax return. Review your tax withholding carefully to avoid owing money later.

What Happens If Your Refund Isn’t Fully Protected

If your refund isn’t fully covered by exemptions, the trustee may require you to turn over the non-exempt portion. Handle the situation carefully to avoid complications.

Don’t spend the refund. Spending a non-exempt refund can cause the bankruptcy court to deny your discharge. The court could even revoke a discharge that’s already been granted.

Notify your trustee immediately. Tell them you’ve received or are expecting a refund. Ask how to turn over the non-exempt portion properly.

Failing to disclose or turn over a non-exempt refund creates serious legal problems. Be up front with the trustee from the start.

The Trustee’s Role in Managing Tax Refunds

The bankruptcy trustee oversees your case and likely asks about expected tax refunds. During your 341 meeting of creditors, you’ll answer questions about any refunds.

You must include expected refunds as assets on your bankruptcy forms. The trustee determines whether the refund is exempt or should pay creditors.

Honesty is critical. Disclose all expected refunds on your forms and at your meeting.

Can You Eliminate Tax Debt in Bankruptcy?

Bankruptcy can help eliminate certain tax debts. The specifics depend on your bankruptcy type and the nature of the tax debt.

Chapter 7 can discharge tax debt more than three years old. The tax return must have been filed on time. The IRS must have assessed the debt at least 240 days before filing.

You must be up to date on all income tax filings. You cannot have committed fraud or tax evasion.

In Chapter 13, tax debts are priority debts. You must pay them in full through your 3-5 year repayment plan. While these debts aren’t dischargeable, Chapter 13 allows you to manage payments without additional interest or penalties.

If you’re struggling with tax debt, speak with a bankruptcy attorney for free to understand your options.

Tax Refunds in Chapter 13 Bankruptcy

In most Chapter 13 cases, you won’t keep your tax refunds during the 3-5 year repayment plan. Both pre-filing refunds and refunds based on income earned during your plan are part of your bankruptcy estate.

Your bankruptcy trustee can take these refunds and use them to pay creditors. The refunds become part of your payment plan.

How Trustees Handle Tax Refunds in Chapter 13

Each Chapter 13 trustee has their own policies for handling tax refunds. Some trustees may:

• Automatically take all refunds you receive during your case
• Allow you to keep the refund if you prove it’s needed for necessary expenses
• Only take refunds that exceed a certain dollar amount

Contact your trustee’s office to learn about their specific policy. Understanding the rules helps you plan accordingly.

Getting Help With Your Bankruptcy Case

To keep as much of your refund as possible, consider using exemptions. Spend the refund on essentials before filing. Or adjust your tax withholding to avoid overpaying.

If you’re unsure about how exemptions apply in your case, professional guidance helps. A bankruptcy attorney can provide personalized advice for your situation.

You can protect your refund and successfully navigate bankruptcy. Understanding the rules and planning ahead makes all the difference.