Stimulus Payments in IRAs

IRS announces solution

By Kaye A. Thomas
Posted May 1, 2008


Some people will see stimulus payments deposited directly to their IRAs.

Partly to reduce paperwork and expense, and partly to get the money in your hands quicker, wherever possible the IRS is using direct deposit to send out stimulus payments. The money goes to the account you specified for direct deposit of your income tax refund. If you were clever enough to specify that your income tax refund should go directly to your IRA, your stimulus payment will also go directly to your IRA.

No problem if that's what you wanted to happen. You'll be treated the same as if you received the stimulus payment, cashed the check, and made a deposit to your IRA. In a traditional IRA you'll be able to claim a deduction for the contribution if you otherwise qualify. In any event, it's a nice boost to your retirement savings.

Not everyone will be happy with this result, though. This added money may put you over the limit for the year, resulting in an excess contribution that may incur a penalty. You can avoid the penalty by taking a corrective distribution, but paperwork and the need to withdraw earnings attributable to the excess contribution will take a lot of the fun out of getting a stimulus payment.

Even if it's a permitted contribution, you may have had other plans for this money. If you want to spend the money (and stimulate the economy, which is after all the original idea), you'll need to take the money out of the IRA. But that means taking a distribution that may be partly or entirely taxable, and possibly subject to a 10% early distribution penalty.

IRS solves problem

Fortunately, the IRS has offered an elegant solution. If your stimulus payment went directly into your IRA you can withdraw some or all of that amount and you'll be treated as if the money you withdrew never went in or came out. You won't have to withdraw earnings attributable to this part of your account, and you won't have to report income on the distribution.

Q: What if my payment went into another kind of account, like an Archer MSA, Coverdell education savings account, or 529 plan?

A: The same rule applies to these accounts. You can take the money out and be treated as if it never went in.

Q: Can I use this rule to withdraw my income tax refund?

A: No, this special rule applies only to stimulus payments that went into one of these accounts by direct deposit.

Q: How do I notify the financial institution that I'm using this rule?

A: You don't. Simply take the money from the account as if it were a normal distribution.

Q: Then how will they know it isn't a taxable distribution?

A: Chances are they won't, so the forms you receive next January may indicate you received a taxable distribution. But that's okay; the IRS says they'll provide a way to exclude this income on next year's Form 1040.

Q: How much time do I have to use this rule?

A: There's no hurry. You can take the money out any time until next April 15. If you file on extension you'll have until October 15.

Issues

The rule doesn't necessarily solve all problems. If the stimulus deposit creates an excess contribution and the account has investment losses while the money is in the account, you'll face a choice between pulling out the entire amount of the stimulus payment under this rule or dealing with the added paperwork required by the normal corrective distribution rule, which allows you to withdraw a reduced amount when your account loses value.

Then there's the problem of how providers will calculate the taxable amount of other distributions you may take from the account. If they don't know you were using this rule to withdraw a stimulus payment, their calculations will show that some of the earnings have flowed out of the account (even though you didn't have to pay tax on those earnings) and that will affect the calculations on other distributions you may take the same year or in later years.

This is probably the best the IRS could have done, though, with the situation handed to them. Taxpayers should be pleased with the rule. In fact, it offers an opportunity for people who want to increase the investment earnings in their IRAs. You can leave the money in the account for a period of time while it generates earnings and then remove it, leaving the earnings behind. That way you stimulate your retirement savings, too.


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