Refund Options for the 2011 Filing Season

Editor: Valrie Chambers, Ph.D., CPA

Procedure & Administration

“Back in the day,” federal income tax refunds were either applied toward the next year’s income tax liability or received by paper check. Over time, the options for receiving refunds have expanded to include direct deposit, refund anticipation loans, and splitting refunds among multiple accounts using Form 8888, Direct Deposit of Refund to More Than One Account. Splitting a refund between an IRA and other accounts is especially advantageous because a taxpayer can fund the IRA for the calendar-year tax return with the tax refund for that year if the tax return is filed early enough for the taxpayer to receive the refund and to fund the IRA account before the April 15 deadline. That is, a taxpayer need not use cash out of pocket on the previous year IRA before filing the tax return.

Beginning in the 2010 filing season for 2009 returns, taxpayers could also purchase up to $5,000 of Series I U.S. savings bonds. This year, purchase options for savings bonds are scheduled to expand to include titling the bonds in the name of a taxpayer and a co-owner, such as a child or a grandchild. The focus of this item is to review the newer refund options: opportunities to fund IRAs for the current tax year with the current-year refund, the purchase of U.S. savings bonds that started last year, and the anticipated forthcoming options for the current year.

Refund Splitting

Since 2007, individual taxpayers have had the option to split direct deposit refunds among up to three different (open) accounts with up to three different U.S. financial institutions that accept direct deposits. Refunds could fund several kinds of accounts, including checking, savings, individual development accounts, IRAs (traditional, Roth, and SEP), health savings accounts, Archer MSAs, and Coverdell education savings accounts.

Refund splitting is subject to both federal income tax rules and the policies of the financial institutions. For example, some financial institutions may not accept a joint refund into an individual account, and if the financial institution rejects the refund splitting request, a paper refund check is sent. If allowed by the financial institution, a refund received by the April filing deadline for tax returns could be used to fund an IRA for the calendar year just ended. The advantages of funding an IRA with a tax refund are an increased IRA deduction and possibly a nonrefundable savers credit of up to 50% of $2,000 per individual (Code Sec. 25B). However, there are some intrinsic traps to funding IRAs in this way.

First, the year for which the contribution is meant to apply needs to be clearly specified; the financial institution’s default may be the year the money goes into the IRA rather than for the previous year. Second, taxpayers should verify the routing and account numbers, in part so they confirm they are funding their own account, not inadvertently contributing to someone else’s. Where the refund instructions have been obeyed but are inaccurate, taxpayers must work with the bank to recover the lost funds; the IRS assumes no responsibility for taxpayer error. (However, the IRS will correct its own errors.)

Another common error is to omit a digit from an account or routing number or to have deposit slip information that is different from what is on the check. If the bank rejects the routing and account information, the IRS will issue a paper check. This is in contrast to the ordering rules that normally apply to split refunds, where the last account listed is generally considered a “plug,” and any changes to the amount of return for calculation errors are added or deducted from last accounts first (in reverse order) until exhausted. (Offsets for state income tax, child support, spousal support, student loans, or other programs administered by the Treasury Department’s Financial Management Service have still other ordering rules: They are deducted first from the deposit to the account with the lowest routing number, followed by second lowest routing number and then, if necessary, from the account with the highest routing number.) Third, make sure the refund does in fact fund the account before the due date of the tax return; otherwise an amended return will need to be filed for the tax year just passed.

Generally, taxpayers cannot split refunds on amended returns or where an injured spouse claim is made. Nor will forms with clearly changed (e.g., erased or whited-out) information be accepted.

Savings Bonds

Beginning in 2009, the IRS expanded the refund-splitting options to include U.S. Series I savings bonds as one of the (up to) three accounts. If a refund is less than $5,000 and an exact multiple of $50, no splitting is needed if the taxpayer wants to use the entire tax refund to buy bonds. These bonds pay a fixed rate of return based on an adjusted average market yield of the benchmark 10-year Treasury inflation-protected marketable security, plus a variable inflation rate that is adjusted semiannually. These rates are announced in May and November of each year. The interest is credited on the first day of each month but is compounded semiannually as measured from the bond’s issue date. Interest accrues until the bonds are redeemed. Generally, bonds must be held a minimum of 12 months, and there is an early withdrawal penalty equal to the three most recent months’ interest if redeemed between 12 months and 5 years. Bonds are redeemable without an interest forfeiture penalty if held between 5 and 30 years. The interest income on the bonds is exempt from state and local taxes, and federal taxes can either be deferred until redemption or paid annually. And, if used for the payment of qualified education expenses, the interest income may be tax exempt at the federal level as well.

The IRS will override the savings bond purchase request if there is an error in figuring the amount of the refund or if the refund is offset by other taxes or debts such as student loans or past due child support payments. In such cases, a paper refund check will be sent to the taxpayer. Generally, taxpayers can expect to receive the savings bonds separately and by mail in about three weeks.

Last year, savings bonds were issued only in the taxpayer’s name, or joint names for married people filing jointly. Taxpayers with marital problems might want to avoid the joint bond-holding period. Bonds could theoretically be reissued to add the name of a child or a grandchild, but this is generally a taxable event and is subject to the 12-month holding period, so it would not be a feasible option for those who may want to gift part of their refund in bonds to a descendent.

This year, the IRS will begin allowing taxpayers to buy bonds in the joint names of the taxpayer and a co-owner, such as a child or a grandchild. (See 2010 Form 8888 instructions, p. 3, and Treasury’s Treasury Direct website.) Bonds can be registered in the name of a single owner, a joint owner, or a single owner with a named beneficiary. This manner of titling is available only for bonds; any portion of the refund not used to purchase the bonds (or to fund IRAs) will be sent to the taxpayer listed on the tax return, either by direct deposit or as a check in the mail, as the taxpayer elects. Most of these changes are reflected on the new Form 8888. IRS Publication 4830, Buy Bonds with Your Tax Refund (2009), will also likely be updated.

EditorNotes

Valrie Chambers is a professor of accounting at Texas A&M University in Corpus Christi, TX, and a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at Valrie.Chambers@tamucc.edu.