An IRS idea that could cost you

By Jeff Schnepper

It's simple, convenient -- and a recipe for a potential tax disaster. I'm referring to the direct deposit of your income tax refund to fund your 2008 contribution to your individual retirement account.

Can you do it? Sure! But if you or the Internal Revenue Service or the Postal Service or your bank or your IRA custodian blow it, you're looking at a nasty, annoying tax problem.

The Pension Protection Act of 2006 gave you the option of having your tax refund deposited directly into an IRA, a Roth IRA or a SEP-IRA. If you want the refund to be deposited into just one account, you can do that right on your 1040 tax form. You can use Form 8888 (.pdf file) to directly deposit your income tax refund into as many as three accounts.

It is an all-or-nothing proposition. You can't have part of your refund directly deposited and ask for a check for the balance.

In theory, direct deposit into a retirement account is a great idea. You don't have to worry about your refund check getting lost or held up in the mail, and the funds get into your account faster. But if there's any glitch, you're going to be in deep doo-doo. That's a technical tax term.

Here are five reasons why you should be wary about a direct deposit to fund your current IRA contribution:

Your return could be held up in the mail

IRA contributions must be made by the due date of your tax return -- normally April 15. If you file a paper return, there's no guarantee it's going to get there on time.

Many taxpayers procrastinate until the last minute before filing. If you have a refund, there's no IRS penalty for filing late. But if the return is one day late, you've lost the IRA deduction for the current year. That means you're going to have to file an amended return -- using Form 1040X (.pdf file) -- and potentially incur extra preparer costs, in addition to increased taxes. (Yes, extra taxes. Remember, you lost the IRA deduction).

• Video: Check out Jeff Schnepper's filing system

In the worst case, the lost IRA deduction converts your refund into a tax-due return. Now you owe the IRS not only additional taxes, but you may have to pay interest and penalties as well.

IRA guru Ed Slott recommends filing early if you want a direct deposit into an IRA for the current year. If you file a paper return, it should be six weeks from the due date. That's about right now. (So get to work.)

For electronic returns, he suggests filing at least three weeks early.

Wrong year

Say you want to directly deposit your 2008 IRA contribution from your 2008 tax return, filed this year. You have to ensure the contribution is applied to the correct year. Without specific instructions, your IRA custodian could apply the contribution to either 2008 or 2009.

To protect yourself, those instructions should be in writing to the bank or financial institution where you're putting the money.

Even if the IRS gets the return by April 15, if your IRA custodian is notified after that date, contributions will automatically be considered deposits for the 2008 tax year. If so, you've lost your 2008 contribution, and your 2008 tax return will need to be amended.

Continued: Cross-outs, white-outs and wipeouts

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