Ways to Exempt Your Refund in a Bankruptcy

If you're contemplating bankruptcy, you probably have a thousand thoughts running through your mind. At the top of that list are probably concerns about your taxes and what happens once you file. If you are expecting a tax refund, you may be especially worried. Before you decide whether or not bankruptcy is for you, it may help to understand how your filing could affect your refund and what steps you can take to protect it in your effort to create a fresh financial start.

Individuals filing for bankruptcy typically choose between Chapter 7 or Chapter 13 bankruptcy. In a Chapter 7 bankruptcy, a court-appointed trustee will seize all of your non-exempt assets and place them in your "bankruptcy estate." Once compiled, the trustee will then take these assets and liquidate them to pay your creditors. Any unpaid debts that remain will be discharged by the court. By contrast, if you file for Chapter 13 bankruptcy, you won't have to give up any assets; however, you'll pay some or all of your debts over a three- to five-year period. At the conclusion of the repayment plan, any outstanding debt will be discharged.

Your best shot at keeping your tax refund may come in the form of a Chapter 13 bankruptcy. Although these funds are not seized as they would be in a Chapter 7 bankruptcy, they may be used in the calculation of your available income and monthly plan payments. If your available income - without the tax refund - is enough to pay 100 percent of your debt over the term of your payment plan, the trustee will disregard the refund and allow you to keep it. However, if only a portion of your debt is being paid -- anything less than 100 percent -- the trustee will require that the funds be added to your income and used to pay creditors over the course of the plan. The only way to save your refund under this scenario is by proving the funds came from the Earned Income Tax Credit or Child Tax Credit: such monies are exempt under the Bankruptcy Code.

Read More: Chapter 13 Bankruptcy Explained

In a Chapter 7 bankruptcy, tax refunds are commonly seized and placed in a debtor's bankruptcy estate. Whether you'll be vulnerable to the same fate depends on timing. The general rule is that if you receive any property, including tax refunds, 90 days before filing or within 180 days after discharge, it belongs to the bankruptcy estate. This rule applies even if you haven't received your tax refund yet, so long as your right to receive it, all or in part, arose during these periods. Debtors attempt to protect their tax refunds in a variety of ways, from spending the money well before filing for bankruptcy to adjusting allowances on their W-4 form to ensure that little or no refund is received at tax time. However, the most commonly used tactic is finding an exemption under state or federal law.

Both state and federal law provide categories of property debtors can protect from seizure in a Chapter 7 bankruptcy, up to a certain value. For example, under federal law, a debtor can exempt his residence up to $24,060 in value and a motor vehicle up to $4,800. In addition to federal exemptions, states also have their own exemption lists, many of which are more generous than the federal one.

To protect your refund, you will likely use either the federal or your state's "wildcard" exemption, which is a catch-all category that allows you to protect anything you want. Under federal law, you can exempt your tax refund under this category up to $1,280 in value; however, your state's limit is likely higher. You may also be able to exempt the refund, or any amount that remains unprotected, through other exemption categories as well.

In some cases, using exemptions to protect some or all of your tax refund may reduce the exemptions available for other property you may want to protect from seizure. So plan accordingly. Occasionally, a bankruptcy trustee will choose not to go after a refund, even if it is not protected by an exemption. However, this typically occurs only when the amount is too small to justify the administrative costs associated with seizing the property and distributing it to creditors.