There aren’t many creditors that can withhold, or set off, your tax refund before it ever hits your bank account. The most common instance of this is when the IRS keeps your refund and applies it to back taxes owed. But that's not the only time this can happen. The federal government can also withhold all or a portion of your tax refund if you've defaulted on your federal student loans.
Since student loans aren't automatically discharged in bankruptcy, this can be a blessing in disguise. But timing matters. Depending on when the government took your tax refund, you may be better off waiting a bit to file your bankruptcy case. To understand why that is, you first have to understand the trustee’s role and abilities.
Treating Creditors Fairly
Bankruptcy trustees must be sure that all creditors are treated fairly in Chapter 7 cases. This is why the trustee has the power to undo any payments of more than $600 you made to creditors in the 90 days before you filed your bankruptcy case. This is true whether you made a payment voluntarily or it was taken through a garnishment, set off, or bank levy.
The Bankruptcy Code includes this requirement to level the playing field for unsecured creditors. Essentially, filers can't give preferential treatment to one creditor over another. If they do, the trustee can take back any payments the filer made to that creditor and split the funds equally among all their creditors.
In many cases, filers aren’t affected when a trustee takes back a preferential payment and redistributes the funds to all creditors. At this point in the bankruptcy process, the filer is well on their way to a discharge.
But student loans are different from other unsecured debts that get discharged in bankruptcy. It’s very hard to discharge student loans in bankruptcy. Most Chapter 7 bankruptcy filers still owe their student loans even after getting their discharge. This is why it matters if and when the government takes your tax return to pay down your student loans. If it happens within 90 days of your bankruptcy filing, it’ll be seen as a preferential payment.
Why Timing Matters When a Refund Is Taken To Pay Down Student Loans
This is easiest to illustrate with an example. Let’s say Debbie was supposed to get a $5,000 tax refund from the IRS but the Department of Education intercepted her refund and applied the full amount to her student loan. This brings her student loan balance down from $7,000 to $2,000. While Debbie didn’t get a say in how the $5,000 was spent, and she may have had other plans for it, her student loan balance has been drastically reduced.
Now let’s look at how this interacts with a potential bankruptcy filing.
Debbie files bankruptcy less than 90 days later. This allows the trustee to get the $5,000 back from the Department of Education and pay a portion of it to each of Debbie’s creditors. Debbie's student loan balance goes back to almost $7,000 and she continues to owe this money even after her discharge is entered.
Debbie files bankruptcy more than 90 days after the Department of Education takes her refund. This means the trustee doesn’t have access to that $5,000 and can’t take it to repay her other creditors. After her discharge is entered, Debbie's only remaining debt is the $2,000 she owes on her student loans.
So When Should I File?
Most bankruptcy filers are dealing with lots of different financial issues, so the answer to this question is, “It depends.” It’s unique for each individual.
Sometimes people need to file their case before a certain date to stop a foreclosure, repossession, or garnishment that’s about to start. Other times, there’s no hard deadline to file. It’s up to each individual filer to decide what’s best for them when it comes to timing, especially since the protections of the automatic stay don’t start until you file your case with the court.
Those who have the ability to wait to file bankruptcy often choose to wait until 91 days have passed from the date that their tax refund was taken by their student loan lender. While this means they’ve lost their tax refund for good, it also means that 100% of that tax refund goes toward paying down their non-dischargeable student loan debt.