couple discussing recharacterization of an IRA with financial advisor
couple discussing recharacterization of an IRA with financial advisor

What is a recharacterization of an IRA?

Individual Retirement Accounts (IRAs) are very useful tools for retirement savings. They offer tax advantages that encourage people to save for their future. There are two core types of IRAs that most people are familiar with: traditional and Roth. While they share many similarities, they offer different tax treatments. If you have both types, you may occasionally find that your IRA contribution went into the wrong type of account for your tax circumstances. This is where recharacterization comes into play.

Today, recharacterization allows you to move an IRA contribution from one type of IRA to the other—a circumstance that can arise as you are determining your tax liability for the year.

Are IRA recharacterizations still allowed?

Yes, IRA recharacterizations are still allowed, but with limitations. The Tax Cuts and Jobs Act (TCJA) of 2017 brought significant changes to the recharacterization rules. Before 2018, recharacterization allowed investors to undo IRA conversions; that’s no longer an option. 

Currently, you can only recharacterize contributions, not conversions. What does that mean from a practical perspective? If you contribute to a Roth IRA and later decide you would prefer that contribution to be in a traditional IRA (or vice versa), you can still make this change under certain conditions.

You may also be interested in: IRA to Roth conversion: Should you change your retirement plan?

What is the difference between an IRA conversion and recharacterization?

An IRA conversion involves moving funds from a traditional IRA to a Roth IRA. Conversions are frequently recommended in order to take advantage of the tax-free growth offered by Roth IRAs. When you convert, the amount you move is subject to income tax, but future earnings and withdrawals are tax-free under Roth IRA rules.

Recharacterization, on the other hand, is the process of changing the nature of a contribution from one type of IRA to another. For example, if you initially contributed to a Roth IRA but later decide that a traditional IRA would be more beneficial, you can recharacterize that contribution. In order to recharacterize a contribution, you must transfer it, along with any earnings, to the new type of IRA.

Another way to remember it: a conversion changes the type of IRA you have, while a recharacterization affects a specific contribution.

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What is the reason for recharacterization of an IRA contribution?

Recharacterization of a traditional IRA contribution to a Roth IRA (or vice versa) is often done for tax planning purposes. For instance, if you made a contribution to a traditional IRA but found out later that you don’t qualify for the tax deduction because your income is too high, you might decide to recharacterize to a Roth IRA to take advantage of tax-free growth and withdrawals.

Conversely, if you contributed to a Roth IRA but realize you would benefit more from an immediate tax deduction, you might choose to recharacterize your contribution.

What are the rules for recharacterization of IRA contributions?

The rules for recharacterization are specific:

  1. Timing: You must complete the recharacterization by the tax filing deadline for the year the original contribution was made, including any extensions. For most people, this means the deadline is October 15th of the year following the contribution.
  2. Process: You need to transfer the amount contributed plus any earnings (or less any losses) to the new IRA. The transfer must be reported to the IRS, and the recharacterization should be done as a trustee-to-trustee transfer.
  3. Reporting: You need to inform both the financial institution managing your IRA and the IRS. Your IRA custodian will handle most of the reporting, but you will need to indicate the recharacterization on your tax return using IRS Form 8606.

What are the tax consequences of Roth IRA recharacterization?

When you recharacterize a Roth IRA contribution to a traditional IRA, you are essentially undoing the initial contribution. For tax purposes, it’s as if the original contribution was made to the traditional IRA. A Roth-to-traditional IRA recharacterization can be beneficial if you need a tax deduction for the year of the contribution.

The earnings on the recharacterized amount must also be transferred to the new IRA. These earnings will be taxed according to the rules of the new IRA type. If you recharacterize a Roth IRA contribution to a traditional IRA, the earnings will be subject to tax when withdrawn from the traditional IRA in the future.

Example of an IRA recharacterization

Let’s consider the case of John, who initially contributed to a Roth IRA but later decided to recharacterize his contribution to a traditional IRA due to changes in his financial situation.

John made an initial contribution of $6,000 to his Roth IRA on March 1, 2023. By mid-2023, John realized that he would benefit more from the tax deduction available with a traditional IRA. His business expenses for the year ended up being lower than expected, and he could use the immediate tax break.

Steps John took to recharacterize:

  1. Contacting his IRA custodian: John contacted his financial institution managing his Roth IRA and informed them of his intention to recharacterize his contribution to his traditional IRA.
  2. Calculating the amount to transfer: By the time John decided to recharacterize, his $6,000 Roth IRA contribution had earned $200 in investment gains. Therefore, the total amount to be transferred was $6,200.
  3. Completing the transfer: John filled out the required recharacterization forms provided by his IRA custodian. The custodian then transferred the $6,200 from the Roth IRA to a new or existing traditional IRA account via a trustee-to-trustee transfer.
  4. Reporting the recharacterization to the IRS: When John filed his taxes for the year 2023, he reported the recharacterization on IRS Form 8606. This form was used to indicate the movement of funds from the Roth IRA to the traditional IRA. Since the contribution was now considered as if it had been made to the traditional IRA originally, John also ensured that the $6,200 was correctly reflected in the new account.

Since John recharacterized his Roth IRA contribution to a traditional IRA, he doesn’t owe tax on the $200 gain at the time of recharacterization. Instead, the gain will be taxed when he withdraws the funds from the traditional IRA in retirement.

By recharacterizing his IRA contribution, John optimized his retirement strategy to better align with his financial circumstances, securing a tax deduction for the 2023 tax year and positioning his savings for future tax-deferred growth.

IRA recharacterization is a valuable tool in the right circumstances

IRA recharacterization can be a valuable tool for optimizing your retirement savings strategy, especially if your financial circumstances change. To make an informed decision, it’s important to understand the difference between conversions and recharacterizations, know the rules and deadlines, and be aware of the tax implications. We recommend consulting with a financial advisor or tax professional to ensure you’re making the best choices for your specific situation, and to navigate the complexities of IRA regulations effectively. If you don’t have a trusted advisor, we are available to help.

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