Short Answer: Yes, you are usually able to protect most, if not all, of your tax refund while in bankruptcy.
During the tax season from January through April, it is especially important for both bankruptcy attorneys and debtors to be aware of income tax refunds. One of the most frequently asked questions by the bankruptcy Trustee at 341 creditors’ meetings is “Are you expecting a tax refund?” Most debtors could probably use the extra cash but if it is not properly protected or unwisely spent, the tax refund could end up in the Trustee’s hands.
Starting in November, an experienced bankruptcy attorney will ask a client if he or she is expecting a refund. The client should let his/her attorney know how much their refund will be so that the attorney can protect it with the “wild card” exemption. The “wild card” exemption can be used to protect other personal property as well and cannot exceed a certain total amount. Therefore, it is sometimes necessary to choose between exempting a tax refund and exempting other personal property.
We understand that at times the tax refund is needed to pay for necessities such as repairs to a house or car or is needed for living expenses. It is usually okay to use your tax refund on these types of expenses but it is crucial to discuss this in advance with your bankruptcy lawyer. What a debtor does not want to do is use the tax refund to pay for a fancy vacation which the Trustee will not regard as a necessity. Nor should he/she pay back a family member or business partner as the Trustee views this as favoring creditors. In either case the Trustee could make the debtor repay that money to the Court.
Often times the debtor will not acknowledge the receipt of a tax refund if the IRS withholds any or all of it or if the debtor has already spent it. It’s important for the attorney to ask and for the debtor to tell him/her about all tax refunds including why they have been withheld or how they were spent.
Another way to protect a large tax refund is to ask your employer at the beginning of the year to defer more of your salary or projected bonus into an employer IRA or 401K. Do not wait to get the refund, deposit it into your bank account, and then contribute to a retirement fund. The Trustee can consider the tax refund to be part of your “estate”, which they have control over during the bankruptcy process, and require you to pay it to the court.
The bottom line: The best ways to protect your refund in bankruptcy are 1) file your taxes before you file for bankruptcy so you will know exactly how much your refund will be and 2) consult an experienced bankruptcy attorney to help you navigate some of these complicated tax refund and bankruptcy issues.