Tax stimulus may cause IRA headache

Some taxpayers who requested a direct deposit of their tax refund into an individual retirement account may be in for unpleasant surprises.

What they might not know is that by requesting the direct deposit option, any tax rebate — including the economic stimulus payment — will be deposited into that same IRA. That may cause the taxpayer to exceed the maximum permitted IRA contribution.

To address the situation and provide guidance on how to remove unwanted tax rebates from IRAs without incurring any tax or a penalty, the Internal Revenue Service has issued an announcement.

Beginning in tax year 2007, taxpayers were allowed to deposit their income tax refunds directly to IRAs and split their refunds among multiple accounts, using IRS Form 8888.

Overall, this offered a great way to fund an IRA when the provision is used prospectively, or for the current year, as opposed to treating the refund as a prior-year IRA contribution.

The money is dropped right into the IRA by the IRS when the taxpayer is due an income tax refund. Taxpayers don’t have a chance to spend the refund first, and the funds get into the IRA early in the year, which gives the money more time to grow and compound tax-deferred, or even tax-free if the refund goes into a Roth IRA.

Of course anything that good must also have some drawbacks, and most problems arise when a taxpayer tries to use the refund to finance a prior-year IRA contribution. The refund amount could be different than what the taxpayer expected, leaving him or her with either too little or too much in the IRA, Worse, it could be delayed beyond April 15, leaving the taxpayer with no contribution for the prior year.

These situations could require an amended return. Furthermore, a mistake in the financial institution’s routing number or the account number will certainly create problems for the taxpayer. And, not all institutions will accept direct deposits into an IRA.

Taxpayers who deposited their refund directly to more than one IRA will receive their stimulus payment by check. But taxpayers who deposited their refund into only one IRA will receive their tax stimulus payments as a direct deposit to that same account.

If that happens, the deposit of the tax stimulus payment, in addition to the tax refund deposit, could result in the taxpayer exceeding the contribution limit of $5,000 (plus a $1,000 catch-up if the taxpayer is age 50 or older) for 2008.

For taxpayers who want to spend the stimulus check they receive, having the money deposited directly into an IRA poses another problem: getting the money out. Fortunately, other than the administrative nuisance of retrieving the funds, there is no penalty for doing so.

According to the IRS, the stimulus payment can be withdrawn from the IRA without triggering taxes and the 10% early distribution penalty for someone under age 591/2.

An amount less than or equal to the stimulus payment can be withdrawn up to the taxpayer’s tax filing deadline, plus extensions. For most taxpayers the stimulus payment must be withdrawn by April 15, 2009, unless their 2008 return is on extension to Oct. 15, 2009.

The withdrawal of the tax stimulus amount won’t trigger income tax or the 10% early withdrawal penalty.

The IRA custodian won’t be required to figure out if the deposit or the withdrawal is the taxpayer’s stimulus payment. They will report the deposit on Form 5498 and the IRA distribution on Form 1099-R as they would report any other deposit or distribution.

When Form 1040 is released for filing taxes for 2008, the taxpayer will be given instructions for reporting these transactions. Presumably the transactions will be treated similarly to a rollover.

The net tax effect of the deposit and withdrawal will be treated as though they never happened.

The announcement doesn’t indicate how to treat any gain or loss on the stimulus payment while it is in the IRA. However, the full amount of the stimulus payment can be withdrawn even if there are losses in the IRA, according to the announcement.

If there are gains, they can be left in the account and they won’t be considered a contribution to the account.

In short, you and your clients may be in for quite a few headaches with very little to show for it.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., also has created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

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