Protecting Tax Refunds from Creditors through Bankruptcy

Tax refund season is the ideal time of year for judgment creditors to levy (aka “freeze”) bank accounts to collect on debts. Debt collectors know that freezing bank accounts is a quick and easy way for it to collect on its judgment debt compared to the drawn-out process of garnishing a paycheck. A levy is a legal order requiring your bank to remove money from your account and turn it over to the judgment creditor to whom you owe a debt. ​

Can bankruptcy stop an IRS levy?

To remove the levy, you must either pay the bill in full or show that the funds in the account are legally exempt from the reach of a creditor. Unfortunately, large tax refunds are not likely to be exempt funds for purposes of defeating a levy. Bankruptcy relief can help!

If I file bankruptcy will “they” take my tax refund?

Filing bankruptcy imposes an automatic stay on most collection activities, including garnishments and bank levies. Simply put, if a creditor freezes the funds in your bank account to satisfy their money judgment and you file for bankruptcy protection, the automatic stay kicks in and the judgment creditor is required to release the hold on the funds. Whether those funds are reachable by a bankruptcy trustee depends on certain factors such as the amount and whether you are able to claim an exemption to keep the funds. The law provides exemptions to protect your cash in many instances.

Can a creditor garnish your tax refund?

Creditors may be able to garnish your tax refunds under many different circumstances.

Does bankruptcy affect your tax refunds?

​The short answer: yes. Filing a Chapter 7 or Chapter 13 bankruptcy will immediately prevent a creditor from removing money from a bank account that is or could otherwise be levied against. Contrary to popular belief, it is often very possible to protect cash, within certain limits, such as tax refunds when filing bankruptcy in New York. This ability is largely the same whether you have already received your refund or whether you expect to in the near future.

Chapter 13 Tax Refund

Debtors about to enter or who are in a Chapter 13 bankruptcy (3-5 years in duration) must often make plans to not only protect the refund in the year of filing, but also each year while the bankruptcy is pending. Here in the Northern District of New York, the traditional rule is to allow debtors in a chapter 13 reorganization to retain the first $1500 of any tax refund each year with any surplus being potentially reachable by the Trustee to repay certain creditors’ claims. 

Can I keep my tax refund after filing Chapter 13?

There are exceptions to the rule stated in the question above such as earned income credit. In addition, if you can demonstrate actual need to retain the amount over the limit the trustee will allow you to retain it. To the extent possible debtors in an active Chapter 13 would be wise to ensure proper payroll deductions to limit their tax refunds at the end of the year, which has the added benefit of receiving more funds in their paychecks.

Chapter 7 Tax Refund

Debtors filing a Chapter 7 (3-4 months in duration) usually only need to consider how to protect the present year’s tax refund. Some examples are to actually spend the refund before filing on necessities (finally get the new tires you need!)  or determine if the amount is exempt from the reach of the trustee.

Can you keep your tax refund after filing Chapter 7?

If the amount of the refund is within the allowed exemptions, then you can keep it. Remember that joint filers (spouses) are each entitled to their own separate exemptions.

Tax Refund Lawyers

If you are struggling with your bills and are concerned about how to protect your income tax refund, give the Barbaruolo Law Firm a call. Pre-bankruptcy exemption planning is not only permissible, but strongly suggested. Remember, it’s better to be pro-active than reactive!