An IRA recharacterization allows you to make changes to the type of contribution you made to one IRA by transferring it to a second IRA within the same tax year. For example, you might recharacterize traditional IRA contributions as Roth contributions, or vice versa.
This process is different from an IRA conversion, which is not limited to the tax year in which you made a contribution. A conversion typically involves moving funds from a traditional IRA into a Roth IRA, not the reverse. In most cases, you would owe income tax on the amount converted to a Roth.
There are different reasons for the recharacterization of an IRA, and some important IRS rules to know for completing one.
Key Points
• An IRA recharacterization allows you to change the type of IRA contribution made within the same tax year, such as from traditional to Roth IRA or vice versa.
• Executing a recharacterization typically involves notifying the IRA custodian, opening a second IRA, if needed, and meeting the tax-filing deadline or extension.
• Reasons for recharacterization may include avoiding tax penalties for excess contributions, or taking advantage of certain tax benefits.
• A recharacterization differs from a conversion, which can be done anytime with contributions from multiple years, and typically involves moving funds from a traditional IRA to a Roth IRA.
• Following the Tax Cuts and Jobs Act passed in 2017, a conversion from a traditional IRA to a Roth IRA cannot be reversed using a recharacterization.
What Is an IRA Recharacterization?
An IRA recharacterization allows you to treat contributions made to one type of IRA as contributions made to a second, different type of IRA. The IRS allows taxpayers to recharacterize contributions to traditional or Roth IRAs only up until the tax-filing deadline each year, assuming you meet relevant income limits and other restrictions for the second IRA account.
For instance, say you deposit money in a Roth IRA, but when it’s time to file taxes you realize that you’ve made contributions in excess of what’s allowed for your tax filing status and income (see details below).
You could execute a recharacterization to have some of that contribution amount treated as traditional IRA contributions for the tax year, and transfer the assets (and any earnings or net losses) to the second IRA.
In that scenario, a recharacterization of Roth IRA contributions could allow you to avoid the 6% excise tax penalty the IRS imposes on excess contributions.
How Do IRA Recharacterizations Work?
IRA recharacterizations work by allowing you to change your IRA contributions for the year from one type of IRA to another. The process is fairly simple; you’ll just need to notify the company, a.k.a. the custodian that holds your IRA, that you’d like to recharacterize your contributions, and open a second IRA for that purpose (unless you have an existing IRA).
You can also transfer the amount you want recharacterized to an IRA at a different institution. This is known as a trustee-to-trustee transfer. In most cases, either one of these methods is preferable to withdrawing the money and redepositing it yourself, which can be tricky and could lead to taxes and/or a penalty if you fail to transfer the money within a 60-day window.
Again, you have until the annual tax-filing deadline to complete an IRA recharacterization. If you filed an extension, then you’ll have until the October extension-filing cutoff. You should receive a Form 1099-R documenting the recharacterization that you’ll need to file with your tax return.
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Reasons for a Recharacterization
Why would you need to recharacterize IRA contributions? There are reasons for doing a recharacterization in either direction (Roth to traditional IRA, or traditional IRA to a Roth). You might consider recharacterization if you:
• Contributed too much to a Roth IRA for the year and need to shift some of that money to a traditional IRA in order to avoid a tax penalty.
• Made traditional IRA contributions, but later learned that you can’t deduct them because you’re covered by a retirement plan at work and your income puts you over the threshold to claim a deduction.
• Contributed to a Roth IRA, but believe you’d benefit more from getting a deduction for traditional IRA contributions.
• Initially contributed to a traditional IRA, but later decided that you’d prefer to contribute to a Roth IRA to enjoy its tax benefits later in life.
Sample Calculation of IRA Recharacterization
How you calculate an IRA recharacterization can depend on whether you’re recharacterizing some or all of your contributions for the year. To keep things simple, let’s assume that you contributed $5,000 to a Roth IRA at the beginning of the year. The IRA earned $1,000 in investment gains.
You’d now like to recharacterize the entire amount to a traditional IRA. You’d tell your IRA custodian that you’d like to do a full recharacterization. This strategy does not require a separate calculation of investment earnings, because the entire balance of the IRA is being recharacterized.
However, if you only wanted to convert $3,000 of your contributions you’d have to do a separate calculation to figure the amount of earnings that need to be recharacterized.
The IRS offers a formula for doing so, which looks like this:
Net Income = Contributions x (Adjusted closing balance – Adjusted opening balance) / Adjusted opening balance
If you don’t want to do the math by hand, it might be easier to plug the numbers into an IRA recharacterization calculator, or consult with a tax professional.
Pros and Cons of Recharacterizing an IRA
There are pros and cons to using a recharacterization strategy.
Pros
IRA recharacterization offers some flexibility with regard to how your IRA contributions are treated, if your financial circumstances or tax considerations change.
If you start off the year making one type of IRA contribution, you can decide to switch things up at any time before the tax filing deadline. There’s no penalty for changing your mind about what type of IRA contributions you’d like to make, as long as you’re doing so before the filing or extension deadlines.
Recharacterizing an IRA is a simpler process than converting IRA assets, which we’ll discuss shortly. There’s less paperwork involved, and since the transaction can be completed by the custodian without any money being withdrawn from your IRA, a recharacterization can be a more tax-efficient way to adjust your contribution choices.
Cons
That said, there are downsides to a recharacterization. For one thing, you’ll need to be mindful of the tax filing deadlines if you want to recharacterize IRA contributions. If you miss the tax or extension deadline, you won’t be able to recharacterize your contribution amount.
If you recharacterize traditional IRA contributions as Roth IRA contributions, you will owe taxes.
If you recharacterize Roth IRA contributions as traditional IRA contributions, you can only claim the tax deduction a) if you qualify and b) you cannot deduct any earnings on the original contribution, if there were any.
Recharacterization vs. Conversion of an IRA
Recharacterization of an IRA and an IRA conversion are not the same thing. When you recharacterize IRA contributions, you’re changing the type of contributions you made for that specific tax year.
When you convert an IRA, you’re moving money from one type of IRA to another that may include contributions from multiple years. Generally, an IRA conversion refers to moving money from a traditional IRA to a Roth IRA.
If you have a Roth IRA, there would be little benefit to doing a conversion to a traditional IRA since you couldn’t then take the tax deduction. Also, if you first converted a traditional IRA to a Roth, it’s no longer possible to convert it back to a traditional IRA, thanks to changes implemented by the 2017 Tax Cuts and Jobs Act.
Amounts rolled over to a Roth IRA from qualified retirement plans cannot be reversed either.
For example, you might have chosen a traditional option when opening your first IRA but later decided that you’d like to have the tax benefits of a Roth IRA. Converting an IRA to a Roth would allow you to make contributions to a Roth IRA if you’d otherwise be prevented from doing so because your income is too high.
As noted, you’d have to pay taxes on the money you’re converting to a Roth IRA, because the money you deposited in your traditional IRA originally was tax deductible. Roth IRAs are funded with after-tax contributions.
| IRA Recharacterization | IRA Conversion | |
|---|---|---|
| How It Works | Recharacterization allows you to change the type of IRA contributions you make for the current tax year. | Conversion allows you to move amounts in one type of IRA to another, typically a traditional IRA to a Roth IRA. |
| Rules | Recharacterizations must be completed before the annual tax filing deadline. | Conversions can be done at any time and may include contributions made over multiple years. |
| Advantages | IRA recharacterization allows some flexibility in deciding what type of IRA contributions you want to make. | Converting a traditional IRA to a Roth IRA can allow you to take advantage of tax-free withdrawals in retirement. |
| Disadvantages | You must complete a recharacterization by the tax filing deadline or extension deadline; you cannot recharacterize IRA contributions pertaining to one year in a subsequent year. | You will likely owe taxes on converted amounts, which can increase your tax bill. |
The Takeaway
Recharacterization of an IRA could make sense if it allows you to gain a tax advantage, or avoid a tax penalty for excess contributions. If you’re unsure whether a recharacterization makes sense, it might be a good idea to talk to a tax professional first.
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FAQ
Are IRA recharacterizations still allowed?
Yes, the IRS still allows IRA recharacterizations. There are some limitations, however, as converted IRAs cannot be recharacterized back, after the fact. You also can’t recharacterize rollovers from a 401(k) or 403(b) to a Roth IRA either.
What is the reason for recharacterizing an IRA?
One of the most common reasons to recharacterize Roth IRA contributions is to avoid a tax penalty for having made excess contributions. It may also be necessary to recharacterize Roth contributions in order to be able to claim a tax deduction for traditional IRA contributions.
Meanwhile, one reason to recharacterize traditional IRA contributions might be that you don’t qualify for the full (or any) tax deduction, and therefore a Roth might look appealing from a tax standpoint.
What is the difference between an IRA conversion and recharacterization?
Converting an IRA means moving assets from one type of IRA to another, typically involving amounts you’ve contributed over several years. Recharacterization of IRA contributions is more limited, and it means you’ve changed your mind about the type of contributions you want to make for the current tax year. A recharacterization of IRA contributions can only be done only for the tax year the contributions were made; an IRA conversion can be done at any time.
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