Income tax refunds play an important part in many family budgets. According to a study conducted by JP Morgan Chase, the average tax refund in the United States is equal to nearly six weeks of the recipient’s take-home pay. And, what happens to those refunds shows how reliant on that money many Americans are. On average, recipients spend more than 70% of their tax refunds within six months. Credit card payments increase by an average of 86% in the week after tax refunds are received, and expenditures on durable goods double.
Californians, on average, receive higher-than-typical income tax refunds. The state ranks #5 in the country for highest average tax refunds. The average refund for a California taxpayer who receives one is $3,439. So, it’s easy to understand why many people considering bankruptcy are concerned about the fate of their tax refunds.
The answer depends in part on the type of bankruptcy you file, and in some cases on the timing of your bankruptcy petition. This is just one reason that it is a good idea to consult an experienced Los Angeles bankruptcy attorney before taking any action–what you don’t know can cost you money.
Tax Refunds and Chapter 7 Bankruptcy
Tax refunds aren’t specifically exempt in a Chapter 7 bankruptcy case. However, California offers two different sets of exemptions, commonly described as “703 exemptions” and “704 exemptions.” The 703 exemptions offer a generous wildcard protection, meaning that the debtor can choose the property to protect under that exemption. So, depending on what other assets a Chapter 7 filer in California has to protect, he may be able to save his tax refund with exemptions.
That won’t work for everyone, though. For example, a Chapter 7 filer with $75,000 in equity in his or her home would likely choose the 704 exemptions, which allow a much larger homestead exemption.
When a tax refund can’t be protected with exemptions, timing counts. Tax refunds are one of the simplest assets for trustees to seize for the benefit of creditors, because the asset is in monetary form and so there’s no valuation or sale involved.
A tax refund needn’t have been received in order to be part of the bankruptcy estate. The return need not even have been filed. On the other hand, if you receive the tax refund before filing, you may be able to use those funds before you file. Making a major purchase with your tax refund may convert one non-exempt asset into another, meaning that you may lose the item purchased. And, while you can pay some bills with a tax refund received pre-filing, other types of payments may be considered a prohibited “creditor preference,” or even a fraudulent transfer.
Therefore, it’s important to talk to an experienced bankruptcy attorney in advance and make sure you understand which types of expenditures are permissible and which may cause problems later. If you plan far enough in advance, you may even be able to adjust withholding or divert more earnings into pre-tax retirement accounts.
Tax Refunds and Chapter 13 Bankruptcy
In a Chapter 13 bankruptcy plan, the debtor enters into a three to five year plan to repay creditors. Certain types of debt, including secured debts, get priority in the Chapter 13 plan. But some other creditors, such as credit card companies and payday lenders, may receive only partial payments–or, none at all. How much payment these unsecured, non-priority creditors receive depends in part on the debtor’s disposable income.
Disposable income is calculated by deducting allowable monthly expenses from monthly income, so any income outside that, including a tax refund, is typically considered disposable income. That means the trustee likely can and will take those funds to pay creditors. One possible exception is when the plan allows for 100% repayment without including tax refunds. In that case, since creditors are already being paid in full, tax refund funds may not be needed.
Under certain circumstances, a Chapter 13 filer may be able to successfully request that a tax refund be “excused.” However, that doesn’t mean a chunk of extra cash as a tax refund often does for those not in bankruptcy. Instead, a tax refund will typically be excused only if there is an urgent need, such as an unplanned, necessary expense like a car repair, home repair, or medical crisis. Most people filing for Chapter 13 bankruptcy should expect to turn over any tax refunds to the trustee for the duration of the plan.
Planning for Tax Refunds in Bankruptcy
What happens to your tax refund or refunds is just one of many issues that requires careful planning and management to get the most benefit from personal bankruptcy. Anyone considering bankruptcy, whether Chapter 7 or Chapter 13, should start with a consultation with an experienced local bankruptcy attorney.