Don’t mess with taxes! (with apologies to Texas)
The amount that is withheld from your paycheck depends on the number of exemptions you claim.
Many people deliberately understate the number of exemptions they claim. Maybe they have income outside their employment, and don’t want to get stuck with a big tax bill when it comes time to file. Others may like the idea of getting a big fat tax refund, even though having too much money withheld from your paycheck means that you are lending your money to the government interest-free.
On the other hand, there are some people who overstate their exemptions, figuring that it’s their money, and they’d rather let the extra money earn interest all year instead of lending it to Uncle Sam.
Tax Planning and Bankruptcy
If you are thinking about declaring bankruptcy, proper planning means that your decision about how much to have withheld becomes a little more complicated.
If you are expecting a big tax refund, your bankruptcy attorney will likely advise you to put off filing your bankruptcy petition, if possible, since the refund will be considered part of the bankruptcy estate and therefore available to the Trustee for distribution to your unsecured creditors.
It is perfectly permissible to spend your tax refund for ordinary living expenses, such as food, rent, utilities, medical bills, HOA dues, etc. before you file for bankruptcy. (Do not, however, use the refund to take a vacation, buy luxuries or repay that loan from your uncle.)
Because tax refunds are usually considered part of the bankruptcy estate, most bankruptcy attorneys will also urge their clients not to use the withholding system as a forced saving device.
Tax Withholding Numbers Affect Means Test Results
While that is sound advice, some people go too far in the other direction. Let me explain what I mean. Twice in the recent past, I have had clients who have deliberately reduced the amount being withheld from their paychecks, so that they had more cash available to meet immediate needs. Now, these folks may know that income tax obligations are not typically dischargeable in bankruptcy, but they figure that since they usually qualify for a refund, they won’t owe any taxes anyway. What they don’t realize, however, it that overstating exemptions (that is, minimizing the taxes being withheld) distorts the results of the Means Test. When your attorney analyzes your income and expenses, if the amount withheld is too low, the apparent amount of your disposable income is artificially inflated. Since the Means Test is based on your last six months income and expenses, this may result in your failing the Means Test, and/or increasing the amount of the payments required under your Chapter 13 plan.
If you have been “fiddling” with the number of exemptions you have been claiming, or if you think you may have a large tax refund coming, be sure to inform your bankruptcy attorney. He or she may advise you to change the amount being withheld and/or to postpone filing.