What Happens To A Tax Refund In Chapter 7

A lot of people wonder if they will lose part or all of a tax refund if they file for Chapter 7.  The answer is that it depends, but if you plan carefully, you can maximize the amount of money you can keep from a tax refund.

When you file for bankruptcy, your tax refund — whether you have just received it or you expect to receive it for that year — is considered an asset.  As with all your other assets, if you can cover it with an exemption, the trustee will not be able to take it if you file Chapter 7.  Since the allowable exemption amounts vary, the amount of your tax refund that you can exempt varies.

If you just received your tax refund and it won’t be covered by one of the exemptions, you may want to consider certain strategies.  For example, you could spend the money first before filing for bankruptcy.  But you will have to be sure that you spend your tax refund on necessities like paying your mortgage or rent, medical expenses, food, clothing, etc.  And you will have to keep all the receipts and documentation.  You should not use the money to purchase new assets, especially those that would not be covered by one of the bankruptcy exemptions.  Or you can use your tax refund to pay your bankruptcy attorney the fees and costs of filing your Chapter 7.

If you file for bankruptcy later in the year (October to December), things get a little trickier because your tax refund might come in while the bankruptcy case is pending in the first quarter of the new year.  If it comes in during the case and it is not covered by an exemption, the trustee will likely take it to pay your creditors.  You can, however, try and protect it by reducing the amount of any anticipated tax return.  You could, for example, adjust your tax withholding from your paycheck to a lower amount or you can defer more of your salary into an employer IRA or 401k.  If you choose the second option you will have to do it as part of your payroll deductions because if you get a tax refund into your bank account and then try to make a retirement fund contribution with it, the trustee will try and claim it as asset and claw it back.