How Filing Bankruptcy Impacts Your Income Taxes

When filing for either Chapter 7 or Chapter 13 bankruptcy, it may be possible for taxpayers to keep an income tax refund depending on state laws and other steps taken to secure it. The following are some things for filers to consider to protect a tax refund.

Tax Refunds Are Considered Assets in Bankruptcy

When filing bankruptcy, tax refunds are assets, regardless of whether the person filing has already received the refund or will receive it at a later date. It’s also considered an asset regardless of its current status—whether it’s currently processing or not.

Because a tax refund functions as an asset, it’s possible for taxpayers to protect it when filing for bankruptcy by using a bankruptcy exemption. At the same time, it’s important for individuals to consider the state’s definition of a refund in terms of exemption, as refunds aren’t exempt in a majority of states.

Ways to Protect a Tax Refund When Filing Chapter 7

If a taxpayer wants to protect a tax refund when filing Chapter 7 bankruptcy, there are several ways he or she can approach this, including:

  • Adjusting withholdings early on if expecting a significant refund due to payments deducted from a paycheck.
  • Using a wildcard exemption if the state offers one, which can protect a tax refund or another asset.
  • Filing for bankruptcy after actually spending the tax refund, but only if spending it on essential items including medical bills, food, clothing, a mortgage payment, or even the costs associated with a bankruptcy case.
  • Contributing to either a 401K or IRA prior to depositing the refund into a bank account.

Protecting a Refund When Filing Chapter 13 Bankruptcy

If individuals want to protect a refund in Chapter 13 bankruptcy, they will need to either spend the refund on necessities or use an exemption.

However, this could work differently if the individual is working with a three- to five-year repayment plan, in which case all disposable income contributes to the plan. These plans demand that individuals pay the entire amount to creditors. Any amount under that enables trustees to hold onto tax refunds, which won’t count toward plan payments.

Depending on what someone plans to do with their tax refund, a trustee may allow them to keep it. For example, if an individual requires the aid of tax payment to cover any unanticipated difficulties, it may be possible for him or her to convince a trustee to avoid taking the refund. Unexpected medical bills could count as an emergency situation that might influence a trustee’s decision regarding tax refunds.

Otherwise, the only other way for a taxpayer to prevent a trustee from taking a tax refund is to make adjustments to employer tax withholdings before filing for Chapter 13, which lowers the amount of the refund and, in turn, the amount that the trustee can hold onto.

Whether filing for Chapter 7 or Chapter 13 bankruptcy, these are the best methods for protecting an income tax refund. In most cases, it can be difficult to protect a refund in these circumstances, but there are options available to keep individuals financially protected.