What Happens to Income in Bankruptcy?
When severe financial difficulties arise, you might fear lawsuits or foreclosure. Bankruptcy can offer a solution, but a critical question surfaces: what happens to income in bankruptcy? Understanding this is vital because you need funds for daily life, and knowing how your income is treated can reduce anxiety and clarify your options for debt relief.
The thought of filing bankruptcy often causes significant stress, which is perfectly natural. Concerns about your employment, regular income, and overall financial stability are common. The bankruptcy process does scrutinize your income, and its treatment varies based on several factors, most notably the chapter under which you file bankruptcy.
Understanding How Bankruptcy Views Your Income
Initially, it’s important to define “income” in the context of a bankruptcy case. It generally encompasses all regular money you receive. This includes wages from employment, salary, or earnings if you operate a small business.
Income also covers unemployment benefits, rental income, and occasionally certain government benefits. The bankruptcy court and the assigned bankruptcy trustee need a comprehensive view of your financial affairs. Your income helps them assess your situation and determine how your bankruptcy law obligations will be met.
Your income is a crucial factor because it largely dictates which type of bankruptcy you are eligible for. It also influences how much, if any, you might need to repay to creditors holding your unsecured debt or secured debt. You have likely encountered terms like Chapter 7 and Chapter 13 bankruptcy; income plays a distinct role in each individual chapter.
The Means Test: A Starting Point for Your Income
If you are considering Chapter 7 bankruptcy, you will encounter the “Means Test.” This mechanism allows the court to ascertain if your income is sufficiently low to qualify for Chapter 7. This form of bankruptcy can eliminate many common debts, such as credit card debt and medical debt.
The Means Test examines your average gross monthly income for the six months preceding your bankruptcy filing. This figure, often referred to as your debtor’s current monthly income or current income, is then compared against the median income for a household of your size in your state; these are often referred to as income limits. If your current monthly income is below this median, you typically satisfy the initial part of this test without difficulty.
However, if your household income exceeds the median, there is still a possibility to qualify. The second part of the Means Test allows for the deduction of certain approved expenses from your income. These deductions may include taxes, healthcare costs, and sometimes payments for housing and vehicles, potentially reducing your income below the threshold and allowing you to file Chapter 7 for debt relief.
Required Credit Counseling Before Filing Bankruptcy
Before an individual debtor can file bankruptcy under either Chapter 7 or Chapter 13, the bankruptcy code mandates participation in credit counseling. This required credit counseling must be obtained from an approved credit counseling agency within 180 days before the bankruptcy filing. The purpose is to help individuals assess their financial situation and explore alternatives to bankruptcy, such as a debt management plan, though sometimes bankruptcy is the most viable option.
You must receive credit counseling from an agency approved by the U.S. Trustee Program; your bankruptcy court serving your district can provide a list of approved agencies. If there are insufficient approved agencies available, especially in remote areas, some exceptions might apply, but this is rare. This counseling can often be completed online or by phone and may involve a group briefing or individual session.
Upon completion of the required counseling, the approved credit counseling agency will issue a certificate, which must be filed with the bankruptcy court when you submit your debtor file. Failure to complete this step can result in the dismissal of your bankruptcy case. Additionally, after filing but before receiving a bankruptcy discharge, you must complete a debtor education course, also from an approved agency, focused on personal financial management to help ensure a fresh start.
What Happens to Income in Bankruptcy Under Chapter 7?
Assuming you pass the Means Test and proceed to file Chapter 7, a common question is about the money earned after the bankruptcy filing. For many, the answer brings considerable relief. Generally, any income you earn from your job or other regular sources after your bankruptcy case is filed is yours to keep.
This means your regular paychecks will not be seized by the bankruptcy trustee to satisfy old debt payments. You can utilize this money for your ongoing living expenses, a significant aspect of the fresh start that Chapter 7 offers. This is a primary reason individuals opt for Chapter 7 if they meet the qualifications, as it can halt wage garnishment quickly.
However, a few important exceptions exist. If you become entitled to receive certain significant sums of money within 180 days after filing, this money might be claimed by the bankruptcy estate for your creditors. Such sums include inheritances, life insurance payouts where you are the beneficiary, or proceeds from a divorce settlement. It is crucial to report these occurrences honestly to your attorney and the trustee.
Future Windfalls in Chapter 7
Consider Chapter 7 as primarily a snapshot of your financial condition on the day you file. Your assets and liabilities at that specific moment are central. While future regular earnings are generally protected, these specific unexpected “windfalls” received shortly after filing can alter the situation.
This underscores why maintaining open communication with your lawyer about any major financial changes, even post-filing, is vital. They can advise on how such changes might affect your case. Attempting to conceal assets or income is a serious misstep and can lead to severe consequences, including denial of your bankruptcy discharge.
Chapter 13 Bankruptcy: Income Fuels a Repayment Plan
Chapter 13 bankruptcy treats income quite differently. Instead of merely assessing your income for qualification, Chapter 13 utilizes your income to formulate a repayment plan. This payment plan typically spans three to five years, functioning much like an installment agreement.
In Chapter 13, you propose a plan developed to repay some or all of your debts over this period. The monthly payment amount is predicated on your “disposable income.” This is the sum remaining each month after covering your necessary living expenses, such as housing, food, utilities, transportation, and medical costs.
To file Chapter 13, demonstrating regular income is essential, as you must show the bankruptcy court your capacity to make the monthly plan payments. If you lack a steady income source, Chapter 13 is likely not a suitable option. The official United States Courts website offers good general information on Chapter 13 requirements and procedures.
Calculating Disposable Income in Chapter 13
Determining your disposable income can be somewhat involved. You will need to list all your income sources, including any income from a small business. Following this, you list all your reasonable and necessary monthly expenses, documented in your financial affairs schedules.
The bankruptcy court and the case trustee will scrutinize these expenses to confirm they are not excessive. Payments for luxury items or unusually high expenses are generally not permitted unless a compelling reason exists. The definition of “reasonable” can be subjective, and this is an area where an experienced attorney’s guidance is invaluable for income debtors.
Once your disposable income is established, this amount typically becomes your monthly payment into the plan. These funds are then distributed by the trustee to your creditors, including those holding secured debt and unsecured debt, according to the terms of your confirmed plan. This structured approach can help manage significant obligations like tax debt or student loan payments over time.
Here’s a table summarizing key income differences between Chapter 7 and Chapter 13:
| Feature | Chapter 7 Bankruptcy | Chapter 13 Bankruptcy |
|---|---|---|
| Primary Income Assessment | Means Test (qualification based on current monthly income) | Disposable Income (calculation for payment plan) |
| Income Earned Post-Filing | Generally yours to keep (exceptions for windfalls) | Committed to the repayment plan |
| Main Goal Related to Income | Qualify based on having income below certain income limits. | Fund a 3-5 year repayment plan using regular income. |
| Income Changes Post-Filing | Usually minor impact on the discharge. | Can require plan modification (increase or decrease payments). |
| Wage Garnishment | Stops upon filing due to automatic stay. | Addressed through the structured payment plan. |
| Student Loan Payments | Income not directly used for student loans (debt usually not discharged). | May include payments towards student loans depending on plan terms. |
What If My Income Changes During My Bankruptcy Case?
Life is dynamic, and your income might increase or decrease while your bankruptcy case is active. The impact of such changes varies depending on the chapter you filed. Diligently reporting these changes is a requirement under bankruptcy law.
If you are in Chapter 7, an income change after filing usually does not have a substantial impact. Since Chapter 7 primarily evaluates your situation at the time of filing, a subsequent pay increase typically doesn’t mean you owe more. However, failing to disclose a known, guaranteed large pay raise immediately before filing could pose a problem; transparency is crucial.
Should you lose your job or experience a significant income drop after filing Chapter 7, it generally does not affect the discharge of your debts. The process is already in motion based on your past financial circumstances and the information included when you debtor file.
Income Changes in Chapter 13 Are More Complex
In Chapter 13, however, income changes during the three-to-five-year repayment plan are more significant. Because your plan payment is based on your ability to pay (your disposable income), substantial income fluctuations often necessitate a plan modification. Your trustee will likely need to be informed about any considerable raises or decreases in your current monthly income.
If your income increases significantly, the trustee or your creditors may request the court to raise your monthly plan payments. The principle here is that if your capacity to pay more increases, you should contribute more. This aligns with the “best efforts” requirement in Chapter 13, meaning you are expected to pay what you reasonably can towards your debt payments, including any outstanding federal tax.
Conversely, if you lose your job, your hours are reduced, or you face a significant, unavoidable rise in expenses (like a serious medical issue leading to more medical debt), you can petition the court to modify your plan and lower your payments. In some instances, if the income drop is severe and prolonged, you might be eligible to convert your case to Chapter 7 (if you now meet the Means Test criteria). In difficult situations, if you can no longer afford any plan, your Chapter 13 case could be dismissed, leaving you without the anticipated debt relief from the bankruptcy discharge.
The critical element here is communication. If your income changes while you are in Chapter 13, inform your bankruptcy attorney immediately. They can help you understand your options and take the appropriate actions to manage your payment plan and overall bankruptcy filing.
Specific Types of Income and How Bankruptcy Treats Them
Not all income receives identical treatment in bankruptcy. Let’s examine some common types:
Wages, Salary, and Self-Employment Income
Regular wages and salaries are relatively straightforward. They are factored into the Means Test for Chapter 7 and used to calculate disposable income for Chapter 13. If you are self-employed or run a small business, the process is more detailed; you will need to furnish comprehensive profit and loss statements and business records to demonstrate your income and expenses. Consistency in self-employment income is particularly important for Chapter 13.
Unemployment Benefits
If you receive unemployment benefits, these are generally considered income by the bankruptcy court. They will be included in your Means Test calculation for Chapter 7. In Chapter 13, unemployment benefits contribute to your ability to fund a repayment plan, although the temporary nature of these benefits might be taken into account.
Social Security Income
This is a frequent concern for many considering filing bankruptcy. Generally, Social Security benefits themselves are protected and cannot be directly taken by the bankruptcy trustee to pay creditors. However, this income is often included when calculating your total household income for the Means Test to determine Chapter 7 eligibility.
In Chapter 13, while the Social Security money itself might be protected, it can still demonstrate an ability to make plan payments from other non-Social Security income sources. You can find information on creditor protections on the Social Security Administration website, and this page describes some income exclusions for SSI that provide helpful context.
Disability Benefits
Disability benefits, such as Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI), often receive treatment similar to Social Security. They are usually protected from direct seizure by the case trustee. Nevertheless, they form part of your overall financial picture for the Means Test and for determining your budget in a Chapter 13 plan.
Retirement Income (Pensions, 401(k) Withdrawals)
Funds already held in most qualified retirement accounts (like 401(k)s and IRAs) are generally protected in bankruptcy. You usually do not lose your retirement savings. However, if you are regularly withdrawing money from these accounts as income, those withdrawals will likely be counted as income for your bankruptcy paperwork and calculations of current monthly income.
Bonuses and Commissions
Bonuses and commissions can be somewhat complex because their timing is crucial. If a bonus was fully earned beforeyou filed for bankruptcy but you receive it after filing, it might be considered property of the bankruptcy estate, particularly in Chapter 7. If it is earned and received after filing, it is usually treated as post-filing income. Discuss any anticipated bonuses or commissions with your attorney to understand their impact on your bankruptcy case.
Child Support and Alimony
Money you receive for child support or alimony is generally counted as income for both Chapter 7 and Chapter 13 purposes. It affects your Means Test calculation and your disposable income for a Chapter 13 plan. However, these funds are typically not considered property of the bankruptcy estate that can be taken by creditors, as they are intended for the support of a child or former spouse.
Tax Refunds
Tax refunds can also be a point of interest. A tax refund you are entitled to receive when you file bankruptcy, or a portion of a refund for the tax year in which you file, might be considered an asset of the bankruptcy estate. How much, if any, you get to keep often depends on available exemptions. It is important to discuss your tax returns filed and anticipated refunds, including any from prior years or related to income tax or federal tax, with your attorney.
Using Exemptions to Protect Some Income or Assets
Bankruptcy law incorporates “exemptions,” which are legal provisions that protect certain types of property, and sometimes portions of your income, from seizure by creditors or the bankruptcy trustee. Federal exemptions exist, and each state also has its own set of exemptions. In some states, an individual debtor can choose between the federal and state exemption lists, including here in New York.
For instance, an exemption might protect a certain percentage of your wages from garnishment even before bankruptcy, and similar principles can apply to cash on hand at filing. Some states offer generous “wildcard” exemptions that can be applied to various assets, potentially including cash from recent income or a portion of a tax refund. Correctly understanding and applying exemptions, including those related to unexpired leases or executory contracts if they involve income, is a critical aspect of bankruptcy, and an experienced lawyer is essential for this.
Exemptions do not make your income “disappear” for qualification purposes (like the Means Test), but they do help protect what you already possess or are about to receive. For example, if you have money in your bank account from your last paycheck when you file, exemptions might protect that money from the trustee. This also extends to how assets, including those generating income, are handled in the plan developed for Chapter 13.
Be Honest and Thorough About Your Income
Throughout this entire process, the paramount consideration is to be completely honest and thorough when reporting your income and detailing your financial affairs. You will complete extensive paperwork, including schedules of assets and liabilities and a statement of financial affairs, under penalty of perjury. Concealing income or assets, or not being truthful about your finances, including all tax returns filed for prior years, can lead to very serious problems.
Your bankruptcy case could be dismissed, potentially affecting your ability to refile. You could lose your opportunity for a bankruptcy discharge of your debts. In extreme situations, you could even face fines or criminal charges. The risk is simply not worth it when aiming for debt settlement through bankruptcy.
Gather all your pay stubs, income tax returns (including tax returns for the relevant tax year), bank statements, and any other documents related to your income, whether from employment or a small business. Provide everything to your attorney, even details about executory contracts or unexpired leases that might affect your income or expenses. They are there to assist you, but their effectiveness depends on having a complete and accurate picture of your financial situation.
The Trustee’s Job Regarding Your Income
The bankruptcy trustee, or in some districts a bankruptcy administrator, plays a significant role in your case. This person is appointed to oversee your case and represent the interests of your creditors. One of their primary responsibilities is to review all your paperwork, including your declared income and expenses.
In Chapter 7, the trustee verifies if you correctly passed the Means Test and examines your financial affairs for any non-exempt assets that could be liquidated to pay creditors. In Chapter 13, the trustee reviews your proposed repayment plan to ensure it is fair, feasible, and complies with all legal requirements. This includes confirming that you are dedicating your disposable income to the plan to address debts, potentially including tax debts or student loan payments.
The trustee can ask you questions about your income and expenses at the meeting of creditors (also known as the 341 meeting). They can also request additional documentation if any aspect of your income, such as from a small business or irregular sources, is unclear. Cooperating fully with the case trustee is important for a smooth bankruptcy process and achieving a successful bankruptcy discharge.
Conclusion
Ultimately, what happens to income in bankruptcy does not have a single, straightforward answer. The specifics depend heavily on whether you file Chapter 7 or Chapter 13, the sources of your income (your current income), and your unique financial circumstances. Generally, Chapter 7 allows you to retain income earned after filing for bankruptcy, offering a quicker fresh start from burdens like credit card debt or medical debt, while Chapter 13 uses your future disposable income to fund a structured repayment plan over several years, addressing various debt payments.
Understanding the rules concerning what happens to income in bankruptcy is a critical step toward making an informed decision about your financial future and options for debt relief. Before you file bankruptcy, completing required credit counseling is also a necessary step. Consulting with a qualified bankruptcy attorney like William Waldner is the most effective way to determine how these rules apply to your specific situation and to receive personalized guidance for your bankruptcy filing. Schedule your FREE consultation today!