Tax Season: What Really Happens to Your Future Income Tax Refunds during a Chapter 13 Bankruptcy

Don’t let what you’ve heard about “losing” your tax refunds be a factor in deciding whether to file a Chapter 13 “adjustment of debts.”

 

Making a Wise Choice of Chapter 13 vs. Chapter 7

Chapter 7 “straight bankruptcy,” which is generally completed in less than 4 months from start to finish, and Chapter 13, which usually lasts 3 to 5 years, are VERY different ways of dealing with your financial predicament. In spite of taking so much longer to complete, Chapter 13 is so much more powerful in addressing many special issues that it is often unquestionably the better option, IF you are facing one or more of those issues. In making a good decision between Chapter 7 and 13, focus on concrete ways that each will help you. Particularly look at the ways that Chapter 13 would help in ways that Chapter 7 couldn’t, and whether that additional help is worth the much longer time it takes.  

One consideration that looms large in some people’s minds is how intrusive the Chapter 13 process is during the years that you are in it. That’s a sensible concern. In just about all cases once a Chapter 7 case is finished, the bankruptcy system doesn’t care about what you do afterwards—how much money you make, what creditors you pay and how much, or whether you file your tax returns. But because of how Chapter 13 works, the system cares very much about these things during the life of a case.

One aspect of this—what happens to your tax refunds during a Chapter 13 case—should have no bearing on your decision. This blog post explains why not.

(See our last blog post about the separate issue of dealing with any tax refunds pending as of the time your Chapter 13 case is filed.)

Why Future Year Tax Refunds Matter in Chapter 13

Under Chapter 13, you are protected from your creditors and provided with a budget intended to enable you to meet your reasonable monthly expenses. In calculating that budget, your income is presented as precisely as possible. That income includes not just money you receive from employment but also from all other sources. That includes any tax refunds that you would receive during your case.

The Bankruptcy Code says that a Chapter 13 plan

shall provide for the submission of all or such portion of future earnings or other future income of the debtor to the supervision and control of the trustee as is necessary for the execution of the plan.

In virtually all jurisdictions you have to provide the trustee with annual tax returns to show (among other things) how much in tax refunds you are receiving, and ordinarily you have to pay any such refunds to the trustee, as part of your income.

If you are one of millions of people who have used tax refunds as a way to pay for certain important expenses, losing this annual chunk of money may feel like a big deal. But how this works in practical terms would likely be not as much of a problem as you think, and in fact often actually serves your best interests. 

Incorporating Tax Refunds into Your Monthly Budget

 If you are usually get relatively large tax refunds, your paycheck tax withholdings need to be adjusted so that you are not giving the IRS (and your state taxing authority if you have state income tax) an interest-free loan every year. It’s more honest and wiser budgeting to include in your monthly budget the expenses that you tend to spend your refund on. For example, instead of hoping for a refund to pay for deferred vehicle maintenance and repair, an adequate amount for this expense should be in your monthly budget. Chapter 13 usually allows you to do that, leading to less ongoing worry about whether you’ll have money for this necessity.

After your tax withholdings are appropriately adjusted—increasing your take-home income—that should eliminate or greatly reduce the amount of tax refunds going to the trustee.

Getting Permission to Use a Tax Refund for a Specific Purpose

Bu what if during your Chapter 13 case you still do become entitled to a tax refund? And what if, in spite of best efforts at budgeting in advance for all anticipated expenses, you have an important and urgent expense that you need to spend it on? Depending on all the circumstances of your case, you may be able to use it for that purpose, AFTER getting permission to do so.

It’s important to contact your attorney as early as possible, to find out whether this effort will work before you start counting on it, and also to be able to make the best argument in your favor. You certainly don’t want to wait until you desperately need the money or until after you’ve already spent the refund money without permission; doing so would likely violate a court order.

Putting Refund Money to Good Use in Your Plan

Even if your tax refunds do go to the trustee during your Chapter 13 case, with the result that that money is distributed as designated by your court-approved plan, often paying that extra money into the plan is truly the best use of that money.

First, in some cases (but not all), any extra money paid into your plan beyond the regular monthly payments enables you to finish your case that much faster. That would likely allow you to start building up your credit score sooner, and would simply get you out from under the jurisdiction of the bankruptcy court.

Second, in many Chapter 13 plans especially important creditor are paid earlier than others. Paying extra money—such as from a tax refund—into the plan would often go mostly to such important creditors, which can be to your benefit. For example, if you are behind on child support and catching up on it through your Chapter 13 case, an extra chunk of money to the Chapter 13 trustee could pay that off, reducing the emotional heat from your ex-spouse. Or if you are paying on your vehicle loan in your plan, extra money going to that creditor could build equity in your vehicle and get you that much  closer to paying it off.

Third, if you are butting up to the end of the maximum 5-year period that a Chapter 13 case may legally last, paying some extra money from a tax refund into your case could enable you to meet that 5-year limit. That could be extremely important because it could avoid your case from being dismissed–thrown out—which would truly be a shame after putting years of effort into it.