Tax refund, IRA not a fit

The Baltimore Sun

The intent is good, to encourage Americans to save for retirement. But enough things can go wrong that I must caution against having your tax refund deposited directly into your individual retirement account.

For one thing, I can think of smarter ways to make IRA contributions. If you do deposit your refund, at least protect yourself by making any deductible IRA deposit you request now be for the 2007 tax year, not 2006.

The reason: If you haven't filed your return, even if you do it electronically, the risk is huge that your refund won't be deposited until after the April 17 IRA contribution deadline for 2006.

Any deduction claimed for 2006 then would be disallowed, and you would have to file an amended return. You would also have to pay more in taxes because of the lost IRA deduction.

Or say you make an error in your return and the IRS adjusts your refund. An amount different from what you had expected may be deposited into your IRA.

If lower, you might miss out on contributing all you could.

If higher, you may end up with excess (and therefore illegal) contributions, subject to tax penalties. The tax forms for direct deposit of refunds do not distinguish between IRAs and non-IRA accounts, so nothing in them will alert the IRS if you are putting in more than the law allows.

"With IRS direct deposit you have very little control over the actual amount deposited," said Diana Stephens, tax analyst with Thomson Tax and Accounting.

"Any number of errors," she said, whether by you, the IRS, or your financial institution, "can result in a deposit of more or less than you requested."

Such errors or simply delays in processing your return "could create a nightmare that could take months to unravel," she added.

So who thought this up? Allowing direct deposit of tax refunds into IRAs was a much-hailed provision of the Pension Protection Act approved last summer. Congress' intent was to boost retirement savings among people who felt they could not afford to contribute to an IRA until they received their refund (and who might then use the refund for something else).

My problem with the whole idea - and why I never intend to do it with my IRA - is that it perpetuates a pervasive but misguided view of tax refunds.

"Many individuals are still of the mind-set that a tax refund is a 'bonus' when in fact it just means you gave an interest-free loan to the government" usually by having too much money withheld from your paycheck, said Nicholas Kaster, pension analyst for tax publisher CCH Inc., a Wolters Kluwer business.

Your best step to take if you get large refunds is to boost your take-home pay by lowering your withholding, Kaster said.

Then use the extra money you receive to contribute to your IRA as soon as you can, giving your money more time to grow. You can contribute to an IRA a little at a time and contribute less than the maximum.

"However, in absence of this, a direct deposit into your IRA may help individuals who otherwise have a hard time saving," Kaster said.

Those are the folks Congress had in mind.

"People are more likely to save if they never touch the money," said Ed Slott, a certified public accountant in Rockville Centre, N.Y. "The idea is to make saving easier."

It makes no sense, therefore, to get trapped in a paperwork nightmare by having a deductible contribution miss the April 17 deadline or making an error it could take months to correct.

No wonder the IRS has put six caution icons with exclamation points in the two-page Form 8888, which you must file if you want to split the deposit of your refund into more than one account.

The form explains what you need to do to make sure the amount you want is credited to the right account and, in the case of IRAs, to the right year. This is key: With any account, IRA or non-IRA, it's your job to contact your financial institution to make sure it will accept direct deposit of a tax refund and to obtain the information required by the IRS.

If you are asking that your refund be deposited in a single account, you just fill Line 74 on Form 1040. Still, I recommend you read Form 8888 to avoid common mistakes.

Or if the refund deposit process becomes too much of a hassle, make a direct IRA contribution, which is simpler.

Humberto Cruz writes for Tribune Media Services.

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