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Bankruptcy by Example: Future Income Tax Refunds in a Chapter 13 Case

Oct. 31, 2014

Tax refunds can be 1) better used as money in your budget, 2) spent on approved urgent expenses, or 3) put to good use in your payment plan.

Future Income under Chapter 13

A basic principle of a Chapter 13 “adjustment of debts” is that you must pay what you can afford to pay to your creditors during the course of the 3 to 5 year payment plan. You are allowed to keep enough of your income to pay for your allowed expenses. But the rest goes to the Chapter 13 trustee to be distributed among your creditors in the way that you’ve proposed and the court has approved in your payment plan.

A tax refund is basically money that you’ve earned and was withheld from your paychecks (or that you paid in estimated quarterly payments, if you’re self-employed). You overpaid the amount needed to pay your taxes, so the extra is refunded back to you. If that extra is not offset by allowed expenses, normally those refunds would need to be paid into your Chapter 13 plan and paid to the creditors as specified there.

But you may have gotten into the practice of using tax refunds as a way to save money and to pay for certain expenses. So the prospect of not being able to do this may seem to be a disadvantage. But in practice, because of the way Chapter 13 works this is usually not actually a problem. Here are three reasons why.

1) Avoiding Future Tax Refunds with a More Honest and Healthy Monthly Budget

If you consistently get large tax refunds, the tax withholdings from your paycheck almost certainly should be adjusted downward. Otherwise you are giving the IRS and the Oregon Department of Revenue (ODR) an interest-free loan every year. Avoiding this would be a good idea even if you weren’t in a Chapter 13 case. It’s better and clearer to include enough money in your monthly budget to cover the expenses that you would spend your refunds on. For instance, instead of counting on a future refund to pay for some vehicle maintenance or repair, put an appropriate amount into your monthly budget for this expense. You are allowed to include such expenses in your Chapter 13 budget. As a result you’ll worry less about whether you’ll have money for this expense.

2) If You Do Get a Refund, Get Approval to Use it for a Worthy Purpose

If you do still get tax refunds a year or two into your Chapter 13 case, you can often get permission to spend them on a special expense, one that wasn’t covered in your monthly budget. For instance, you may have budgeted for vehicle maintenance but your car was broken into and you had to pay a deductible to repair a broken window. Depending on the details, you would likely get permission to use the tax refund for this.

3) Putting Refund Money to Work in Your Plan

It may not seem true at first glance, but sometimes paying a tax refund to your Chapter 13 trustee is really the best use of that money. Here are three such situations:

  • Often extra money paid into your plan simply lets you finish your case that much faster, without paying a dime more to any creditor. This would enable you to rebuild your credit faster.

  • Chapter 13 plans often have a very important creditor or two being paid ahead of others. The money from a tax refund paid to the trustee would often go mostly to such important creditors, which would often be to your benefit. For example, if you are behind on your mortgage payment and are catching up on it through your Chapter 13 case, the extra tax refund money would catch you up faster. Besides building equity in your home, that reduces the risk that you would not be able to pay that off and lose your home.

  • A Chapter 13 case is not allowed to last more than five years. Especially if you has some trouble paying the plan payments earlier in the case, paying the tax refund money into your plan could make it possible for you to meet that 5-year limit. That’s crucial because if you don’t finish your case within five years, it could be dismissed—completely thrown out—meaning, among other problems, that all of a sudden you would again owe all your creditors in full. Avoiding that by paying the trustee your tax refunds would be highly worthwhile.

An Example

Before they filed their Chapter 13 case, Jeremy and Jane generally got about $2,000 in combined income tax refunds each year from the IRS and the ODR. Because they simply did not have enough money to set aside and pay for just about any maintenance and repair expenses on their two older vehicles—tires, timing belts, brakes, tune-ups, clutch and transmission adjustments—they relied on those tax refunds to pay for the deferred maintenance.

But once they filed a Chapter 13 case, their budget earmarked money each month for these expenses. They learned to save the money each month that they didn’t need to use for this purpose for when they needed it. This way they got on top of taking care of their vehicles, which actually saved them money and gave them the peace of mind of knowing that a breakdown was less likely. Instead of being unhappy about not getting those tax refunds, Jeremy and Jane were happy to be living more wisely and calmly.