In the bankruptcy case of Sparks, John W. and Betty L.; In re, the bankruptcy trustee’s objection to the debtor’s exemption was denied by the bankruptcy court.The details of the bankruptcy case:

In the Chapter 7 bankruptcy case involving debtors claimed their state and federal income tax refunds as exempt under various state law provisions. However, the bankruptcy trustee objected to the exemptions claiming that the funds lost their exemption status once they were withheld and paid to the government before being returned to the debtors via a tax refund.

The funds in question were payments from the Ohio Public Employee Retirement System and unemployment compensation benefits which are exempt under Ohio’s bankruptcy laws. The bankruptcy court ruled that the withholding by tax authorities did not cause the funds to lose their bankruptcy exemption status.
The bankruptcy court said:
“The trustee has cited no cases or countervailing policies suggesting that a debtor should be deprived of exempt funds simply because the funds were temporarily held by taxing authorities. Indeed, case law generally supports a contrary argument, the proposition that exempt funds should remain exempt it they are reasonably traceable.”
The good news is that debtors who can trace a tax refund to an exempt source can still enjoy the bankruptcy exemption for that tax refund. However, if only a portion of the tax refund can be traced to an exempt source only that income is protected during bankruptcy.