Tax season has arrived! Like every year, many people are looking forward to receiving a tax refund from the IRS.

The tax refund is like a reward that people can use in many ways. But, if you're in major financial trouble and have filed bankruptcy, then that money can be the most valuable easy-to-liquidate asset that trustees can take from you.

Why so? One of the reasons is that the Exemption Laws don't protect your tax refund in bankruptcy. The trustees love to take the tax refund because using that money they can easily pay back the creditors with less effort. They don't need to list the debtor's property for sale to distribute the money to the creditors.

Is tax refund considered as a property of the bankruptcy estate?

When a debtor files bankruptcy, the assets he/she owns become the part of the "bankruptcy estate" including the tax refund.

The trustee may take the tax refund to pay the creditors because it is easier than collecting assets and liquidating assets as I have mentioned earlier.

In many cases (Chapter 7 bankruptcy), debtors don't come up with enough assets or cash so that the trustee can pay back the creditors. In the meantime, if the debtor gets a fat tax refund, then the trustee take the money from the debtor to pay the creditors.

How can a debtor protect the tax refund in bankruptcy?

There are some ways you can keep most, though not all of your tax refund. Have a look:

1. Spend your tax refund as soon as you receive it

The best way to keep the tax refund is to spend the money before filing the bankruptcy. You can spend the tax refund on a variety of expenses like:

  • Insurance
  • Home maintenance and repairs
  • Car payment
  • Car repairs and maintenance
  • Rent
  • Mortgage payments
  • Clothing
  • Educational expenses
  • Medical and dental expenses
  • HOA dues
  • Food
  • Utilities

You can save a part of the tax refund as retirement savings as well.

What to keep in mind?

Don't spend the tax refund on luxury goods, credit card bills, or other unsecured debt payments. The trustee will raise an objection to it and tell you to turn over the tax refund, even if you have spent it.

  • It is advisable to keep a record of your tax refund spending.
  • Seek advice of your attorney to avoid any fatal mistake.

2. See your state's exempt law

If you receive a tax refund after filing the bankruptcy, then that money will be granted as a part of the bankruptcy estate as I have mentioned before.

But, in bankruptcy, a debtor is liable to keep (exempt) a portion of property regardless of the amount he/she owes to the creditors.

The amount a debtor can exempt based on the state where the bankruptcy petition is filed. So, check out your state's exemption policy to know how much tax refund you can keep.

3. Hire an attorney to avoid mistakes

Asset protection and exemption are complicated subjects. A little mistake can lead to a major loss of tax refund. Try to hire an attorney who can help you filing the bankruptcy and also offers a free consultation and payment plans based on your situation.

4. Delay your bankruptcy petition if you can't exempt your tax refund

Delay your bankruptcy filing if the tax refund is not exempt. Wait for some time, receive the tax refund and spend on the above-listed things before filing chapter 7 bankruptcy.

5. Take a look at W-4 and adjust your exemptions

If you got a fat tax refund last year, then it is advisable to have the necessary taxes withheld from your paycheck. Try to keep the tax refund small instead of giving the whole refund to the trustee. Take advantage of the IRS’ withholding calculator to know how many deductions you need to claim.

Lastly, if you file bankruptcy between August and December, the trustee may ask you for that year's tax refund copy as soon as you file a tax return. If the trustee notices that you are going to be drawing tax refund, then he will ask you for a portion of tax refund for paying the creditors.

To avoid this loss, it is advisable to file bankruptcy by adjusting your payroll deductions. This way, you can keep money in each paycheck and avoid giving the whole tax refund to the trustee.

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