Tax season is upon us. This is the time of year when people filing bankruptcy have to consider what will happen to their tax refunds when they file. In 2021, things are even more complicated because the amount of a person’s next stimulus check might depend on whether she has filed her 2020 tax return or not.
Tax Refunds in Bankruptcy
Tax refunds are subject to being taken by the bankruptcy trustee. In Chapter 7, the trustee can take all of the prior year’s refund, if it hasn’t been received and spent before a debtor files; and the trustee is entitled to a share of the current year’s refund, based on when the debtor files. Suppose a debtor has not filed her 2020 return before she files Chapter 7. The trustee will be entitled to all of that refund when the debtor receives it. It’s possible the trustee won’t take the refund because it’s too small, but all is at risk. Additionally, depending on when in 2021 the debtor files, the trustee is entitled to that portion of the refund from January 1, 2021, through the day the debtor files. Often the trustee will not take the current year’s portion if the debtor files early in the year, but by summer and later, expect the trustee to request a copy of the current year’s return next year when the debtor files her taxes.
In Chapter 13, a debtor must submit all but $1,000 of her tax refunds to her plan for the first three years of the plan. If the debtor is entitled to an Earned Income or Additional Child Tax Credit, the debtor may keep up to an additional $1,000, for a maximum of $2,000 from her refund, and pay the rest into her plan.
Stimulus Payments in Bankruptcy
Congress is debating right now about a third round of stimulus payments, up to $1,400 more per person. The stimulus payments made in 2020 were exempt from bankruptcy trustee’s clutches. It appears the same will be true for payments made in 2021. For cases filed between December 27, 2020, and March 27, 2021, stimulus payments in the form of advance tax refunds are fully protected. For cases filed after March 27, 2021, and through December 27, 2021, stimulus payments are not considered part of a person’s bankruptcy estate and are therefore not subject to the trustee. However, care should be taken to segregate any stimulus money so it can be identified. If funds go directly to a checking account that contains wages and other funds, they might become commingled and lose their exempt status. Therefore, it would be wise to remove those funds immediately and place them in a separate account, such as a savings account, where they can be easily identified.
File Taxes Before or After Stimulus Payments?
The latest round of stimulus payments is linked to income and begin to phase out at $75,000 Adjusted Gross Income (AGI) for single filers ($150,000 for those filing jointly) and are completely phased out at $100,000 AGI for single filers ($200,000 for joint filings). Because the third round of stimulus payments will begin right smack in the middle of tax filing season, and because the amounts are based on the most recently filed return’s AGI, any big changes from 2019 to 2020 could affect the amount of a stimulus check. For example, if someone earned $80,000 in 2019, based on the 2019 AGI he would have his stimulus check reduced. Now suppose he was out of work due to Covid for four months in 2020 and therefore only earned $50,000. If he files his tax return before the next round starts, his AGI of $50,000 for 2020 will entitle him to the full amount. Similarly, the birth of a child in 2020 would add another dependent to a family and could entitle the family to more money. If a 2020 tax return isn’t on file, that extra dependent won’t show up.
Pay Bills or File Bankruptcy with Stimulus Money?
A huge question for people in financial difficulty is, what should I do with my stimulus money? Many people will use it, or be told to use it, to catch up on past due bills. That’s a responsible approach. But consider this: the average American has $20,000 in credit card debt. Maybe the stimulus payment will catch up past due payments, but will that money do anything toward getting rid of the total? Instead of throwing that stimulus payment into the black hole of debt, what if those funds could be used to get lasting relief? That relief could come by using the stimulus money to pay an attorney to file bankruptcy, thereby wiping out all the debt, not just catching up on payments.
Bankruptcy isn’t the right option for everyone. We’ve talked about signs that it might be right for you. If you’re having serious financial problems, you should explore whether bankruptcy is the best option.