There are not 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 a prior year's balance owed. But that's not the only time this can happen.
Another reason for the federal government to withhold all or a portion of your tax refund is if you're in default with federal student loans.
Since student loans aren't automatically discharged in bankruptcy, this can be a blessing in disguise. However, timing matters, and depending on when your tax refund was taken by the government, you may be better off waiting a bit to file your bankruptcy case.
Treating creditors fairly
One of the trustee's responsibilities in a Chapter 7 bankruptcy is to make sure that all creditors are treated fairly. Generally, this means that the trustee has to make sure each unsecured creditor gets a share of the money that the trustee is paying to creditors.
This is also why the trustee has the power to undo payments of more than $600 made to creditors in the 90 days before the case was filed with the court. This is true whether the payment was voluntary or due to a garnishment, set off, or bank levy.
The Bankruptcy Code includes this provision to level the playing field. Filers can't "prefer" one creditor over another and creditors know that racing to the courthouse to collect as much as possible from someone before their bankruptcy case can be filed is a fruitless effort.
Getting the most out of your fresh start
Generally, it doesn't impact the filer when the trustee avoids such a "preferential payment" to distribute the funds to all creditors. At this point, the filer is well on their track to discharge and typically doesn’t care who gets how much from the trustee.
Here's where student loans are (once again) just a little different. Since 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.
Let’s look at an example of how timing can make a difference after a refund is taken to pay down student loans::
Debbie was supposed to get a tax refund of $5,000 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 owed.
Debbie files bankruptcy less than 90 days later. This gives the trustee the ability to get the $5,000 back from the Department of Education and pay every creditor a portion of it. 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 can't undo the taking of the tax refund. After her discharge is entered, Debbie's only remaining debt is the $2,000 owed on her student loans.
When should I file?
Unfortunately, the answer to that question depends. Sometimes it’s important to file a 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 determine what is best for them when it comes to timing, especially since the protections of the automatic stay don’t start until the case is filed with the court.
Those who have the ability to wait with their bankruptcy filing 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 towards paying down their non-dischargeable student loan debt.