Direct deposit stimulus payments to IRAs may be withdrawn penalty-free

Stimulus payments sent to tax-favored accounts by direct deposit may be withdrawn without tax or penalty.

The Internal Revenue Service (IRS) will deposit stimulus payments to whatever account a taxpayer specified for the direct deposit of their 2007 income tax refunds. When that account is an IRA or one of certain other tax-favored accounts, the IRS has ruled that the taxpayer may withdraw an amount less than or equal to the amount of the stimulus payment without having to pay interest or incurring a penalty. The withdrawal must be made before the filing date (plus extensions) of the individual's tax return for 2008, by April 15, 2009 for those filing without an extension.

In the announcement of the ruling, the Service said that it recognizes that financial institutions may not be able to distinguish these contributions and distributions from others that may occur. Therefore the financial institution receiving the direct deposit of the stimulus payment and making the distribution should report the deposit and distribution in the usual manner.

Taxpayers who choose to withdraw their stimulus payments will receive instructions in their 2008 Form 1040 package that will allow them to report the distribution on their individual income tax return in a manner that shows that the amount withdrawn is not subject to taxes or penalties.

The ruling does not solve all problems that can occur when the stimulus payment goes into an IRA. The stimulus payment can create an excess contribution. If the account has investment losses while the money is in the account, the taxpayer must choose 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 permits a reduced withdrawal when the account loses value, according to fairmark.com. If the taxpayer takes other distributions from the account, it can affect calculations on distributions for the same year or in later years.

The ruling also provides an opportunity for people who want to increase the investment earnings in their IRAs, fairmark.com says. The taxpayer can leave the money in the account for a period of time while it generates earnings and then remove it, leaving the earnings behind.

The ruling applies to an IRA, a health savings account (HSA), an Archer MSA, a Coverdell education savings account (CESA), or a qualified tuition program account (QTP) or section 529 program.

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