At some point, you may want to recharacterize an individual retirement account (IRA) contribution to change the initial designation—either to fix a mistake or because you changed your mind. In other words, you can redefine a Roth IRA contribution as a traditional IRA contribution, or vice versa.
For instance, if you made a Roth IRA contribution and then realized your income exceeds the limits for a Roth account, you can recharacterize it as a traditional IRA contribution
Or, you may discover that you are ineligible get the deduction for your contribution to a traditional IRA because you are covered by a retirement plan at work. In that case, you can change it to a Roth IRA contribution, for which the earnings accrue on a tax-free basis.
Here’s a look at how recharacterizations work—and the formula for calculating earnings and losses, if you’re curious about how the math works.
Key Takeaways
- You can recharacterize the current year’s individual retirement account (IRA) contributions from a traditional IRA to a Roth IRA, or vice versa. You must make the change before that year’s tax deadline.
- When you recharacterize an IRA contribution, you must transfer the contribution plus any earnings related to it.
- You can convert the entire balance of your traditional IRA to a Roth IRA at any time by doing a Roth IRA conversion.
- Before the Tax Cuts and Jobs Act (TCJA) of 2017, you could recharacterize (or undo) a Roth IRA conversion back to a traditional IRA.
- Roth IRA conversions are now irrevocable, so you can no longer recharacterize a conversion.
How an IRA Recharacterization Works
To recharacterize a contribution, you move the assets from the IRA that first received the contribution into the IRA where you want the assets to be maintained. Some financial institutions process recharacterizations by simply changing the IRA from one type to another. Check with your IRA custodian/trustee about its procedure and any documentation requirements for processing a recharacterization.
Deadline to Recharacterize IRA Contributions
The deadline for recharacterizing an IRA contribution is the tax-filing deadline for that year, including any extensions you qualify to get. That is, if you file your tax return on time (usually by April 15) and file for a six-month extension, your deadline to recharacterize a contribution is Oct. 15 of that year.
To receive an automatic six-month extension, you must file Form 4868 with the Internal Revenue Service (IRS) either electronically or on paper before filing your tax return. If you file electronically, you’ll receive an electronic acknowledgment once you’ve completed the transaction.
Roth IRA Conversions
You can convert the entire balance of a traditional IRA to a Roth account through a Roth IRA conversion.
Doing so can trigger a hefty tax bill—you will owe ordinary income tax on the entire converted amount at your current tax rate. Still, it can be worth it if you expect to be in a higher tax bracket in retirement than you’re in now and want to get the taxes out of the way.
The best time to do a Roth IRA conversion is when your income is unusually low or if a market downturn has taken a substantial bite out of your traditional IRA.
In the past, you could change your mind and recharacterize that Roth conversion back to a traditional IRA. However, the Tax Cuts and Jobs Act (TCJA) of 2017 banned recharacterizing the account balance of a Roth conversion back to a traditional IRA. Roth IRA conversions are now irrevocable.
Calculating Recharacterization Earnings and Losses
Taxpayers who recharacterize their IRA contributions may face the daunting task of calculating their earnings or losses if their IRA provider doesn’t provide such services.
Correctly calculating earnings or losses is as important as the recharacterization itself. The IRS provides a special formula for calculating the earnings or losses on the recharacterized amount. Here is the formula:
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The computation period begins immediately before the contribution being recharacterized is made to the IRA and ends immediately prior to the recharacterizing of the contribution. If the IRA is not valued on a daily basis, then the most recently available fair market value preceding the contribution may be used as the beginning of the period, and the most recently available fair market value preceding the recharacterization is the ending period.
Say, for example, that an IRA is not valued on a daily basis, and the owner receives monthly account statements. If the owner were recharacterizing a contribution in March 2022 and the contribution occurred in December 2021, the owner would use the November 2021 month-end value from the November statement as the beginning period (market value) and the February 2022 month-end statement as the ending fair market value.
IRA Recharacterization Calculation Example
Jack made a contribution of $1,600 to his traditional IRA on Dec. 1, 2020. Before the contribution, his traditional IRA balance was $4,800. In April 2021, when he filed his tax return, Jack realized that he was able to deduct only $1,200 on his tax return. Since he was unable to deduct the remaining $400, Jack decided to put that amount into a Roth IRA, in which earnings grow on a tax-free basis—unlike the earnings in a traditional IRA, which grow on a tax-deferred basis.
To treat the $400 as a Roth IRA contribution, Jack must recharacterize the amount to his Roth IRA and include any earnings (or subtract any losses) on the $400. The value of Jack’s traditional IRA when he recharacterizes the $400 in April is $7,600. No other contributions were made to the IRA, and he didn’t take any distributions from it. Jack calculates the earnings and losses as follows:
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The Calculation for Full Recharacterization
The contribution of $400 earned $75 during the computation period. Jack must, therefore, recharacterize $475 ($400 + $75) to his Roth IRA. For tax purposes, the $400 will be treated as though he made it to the Roth IRA from the beginning.
A calculation of earnings or loss is required only in the case of a partial recharacterization. In other words, if the entire IRA balance is being recharacterized, no calculation is required.
For instance, assume you established a new Roth IRA and funded it with $3,000 in January 2020. By October 2020, the IRA earned $500, making the balance $3,500. To claim a deduction for the $3,000, you decide that you want to treat the amount as a traditional IRA contribution. Because the Roth IRA received no other contributions or made no distributions—and because the IRA had no balance before the $3,000 contribution—you can recharacterize the full balance to the traditional IRA.
Tax-Reporting Forms
Your IRA custodian will report your IRA contributions (to both you and the IRS) on IRS Form 5498. A contribution is reported even if it is later recharacterized. If you recharacterize your contribution, you will receive two Form 5498s—one for the initial contribution and a second for the amount that is credited to the other IRA as a characterization.
You also will receive one Form 1099-R for the IRA that first received the contribution. Form 1099-R is used to report distributions from retirement accounts. Your custodian will use a special code in box 7 of Form 1099-R to indicate that the transaction is a recharacterization and, therefore, not taxable.
Partial recharacterizations must be reported on IRS Form 8606. Form 8606 is filed with your tax return, but you need not file Form 8606 for full recharacterizations.
How Can I Recharacterize an IRA Contribution?
To recharacterize an individual retirement account (IRA) contribution, you need to have another IRA—either existing or new—to accept the withdrawn funds.
Notify your financial institution(s) that you want to recharacterize a contribution. If the same IRA provider maintains both IRAs, you can notify just that institution. Otherwise, you’ll need to contact the custodian holding the first IRA contribution and the institution that will accept the recharacterized contribution.
You can generally do the recharacterization online or by using standard forms provided by the IRA custodian(s).
You must report the recharacterization on your tax return for the year when you made the original contribution, using IRS Form 8606.
How Much Can I Contribute to an IRA in 2022 and 2023?
For the 2022 tax year, you can contribute up to $6,000 to Roth and traditional IRAs, plus a $1,000 catch-up contribution if you’re age 50 or older. That is the combined maximum for all of your IRAs. So, for example, if you add $4,000 to your traditional IRA, the most that you could contribute to a Roth during the same tax year would be $2,000 (or $3,000 for ages 50 and older).
For the 2023 tax year, the limits move up to $6,500. The catch-up contribution remains at $1,000.
Can I Recharacterize a Roth IRA Conversion in 2022?
No. The rules have changed. You can no longer recharacterize a Roth IRA conversion. Once you convert a traditional IRA into a Roth IRA, the move cannot be undone.
The Bottom Line
A failure to accurately calculate and report a characterization can get you into trouble with the IRS. When in doubt, consult with a competent tax professional for help in making the right choices and to reporting it properly.
Also, be sure to submit your recharacterization instructions to your Roth IRA custodian in advance of the deadline.
Source: https://www.investopedia.com/articles/retirement/03/092403.asp?utm_campaign=quote-yahoo&utm_source=yahoo&utm_medium=referral&yptr=yahoo