Don't Mess With Taxes

As sometimes happens when Washington tries to do something that is well-intended, there are unexpected, and unwanted, consequences.

Once such instance is now showing up in connection with the rebate checks now going out. Most of this first round of economic stimulus package payments is being directly deposited into accounts, although I did talk yesterday to a woman here in Austin whose paper check arrived in her mailbox on Monday.

Those directly deposited rebates rely on information you supplied when you filed your 2007 Form 1040. If you got a refund from last year's normal tax filing and told the IRS to put it into a bank account, that's where your rebate money is going, too.

Sounds like a good idea, right? Except if you opted to have all of your refund sent to an IRA. Then we, and by we, I mean you and the IRS, not to mention your IRA manager, could have a problem.

The immediate issue for individuals is that you, speaking hypothetically of course, may not want the rebate money to go into your retirement savings account.

Maybe you've got bills to pay off and were counting on the rebate money to help out. Or perhaps you were going to treat yourself and use the money to buy an item you haven't had the funds to purchase previously. Or were going to take a much deserved vacation using the rebate cash.

Your inability to spend the rebate, especially on something other than necessary expenses, also is a problem for Washington.

Lawmakers approved the payment package in the hopes that new spending sparked by the rebates would give the economy a much needed boost. To their way of thinking, putting the rebates into savings, whether by recipient choice or inadvertently in the IRA direct deposit cases, is not what they wanted.

Finally, if you're an early planner and you've already maxed out or come near the IRA contribution amount for 2008, then this new money could put you over the limit. For 2008, you can put up to $5,000 if you're 49 or younger, or up to $6,000 if you're 50 or older this year, into your IRA, either a Roth or traditional individual retirement account.

IRS withdrawal exception: The IRS hasn't released any statistics on how often this already is happening in the first round of rebates it has issued, but obviously it is an issue because the agency has come up with a work-around for folks in such circumstances.

The IRS has announced that if your rebate money goes to your IRA and you don't want it there, you can make withdrawals from the account in an amount equal to, or less than the payment, and suffer no tax penalties.

So, for example, if your $1,200 stimulus payment goes straight into your IRA, you can withdraw from your retirement account that full $1,200 or, if you decide to save a bit of the rebate, less. The withdrawal in this case will be tax-free and penalty-free

This applies to all tax-favored accounts into which rebates might have been sent per 2007 filing information: an IRA, a health savings account (HSA), an Archer Medical Savings Account (MSA), a Coverdell education savings account (CESA), or a qualified tuition program account (QTP or Code Sec. 529 program).

Different treatment of multiple deposits: If on your 2007 return you opted to have your refund directly deposited into more than one account -- remember, you can put refunds into up to three -- you actually don't have a rebate deposit problem.

In cases where taxpayers designated two or three accounts for direct deposit on their 2007 Form 1040, the IRS will send those folks a paper check.

Time to reconsider: While Dubya and Congressmen and women would love for you to withdraw that errant rebate IRA direct deposit ASAP and spend it, the IRS says you have a while to think about it.

Any such withdrawal of rebate money directly sent to a tax-deferred account can be made as late as when you file your 2008 tax return (April 15, 2009), plus any extensions you might get next year (which would give you until Oct. 15, 2009).

As for record keeping, financial institutions that handle such accounts will report the rebate deposit and distribution in the usual manner. The IRS says it will include instructions in the Form 1040 package that will explain how to report the distribution on next year's return so that it's not subject to existing tax or penalties.

Not for regular refunds: And if you had your regular refund sent to your IRA and now are having second thoughts, sorry. That 2007 refund amount must stay where it is.

This withdrawal rule change applies only to rebate money sent to tax-deferred accounts.

More questions: For my readers who've been sending in (lots of) questions about the rebates, I'm not ignoring you. I just got back into my office after spending a few days on Taxpayer Advocacy Panel duty and am still catching up.

I'll give all your questions a close read and see what I can find out for you in the way of answers. Thanks for your understanding and patience.