IRA Recharacterization

For a variety of reasons, it's sometimes necessary to recharacterize an IRA. One of the more common motives to recharacterize an IRA is when a taxpayer is no longer eligible to make a tax deductible contribution to a Traditional IRA. Under these circumstances, the taxpayer may decide to recharacterize their Traditional IRA contribution as a Roth IRA contribution.

In this publication, we're going to talk about IRA recharacterizations. As part of that discussion, we'll first talk about the different types of recharacterizations and why they might occur. Next, we'll talk about deadlines and the difference between a recharacterization and a conversion. Finally, we'll walk through some example calculations and provide a link to our online recharacterization calculator.

Recharacterizing an IRA

Additional Resources

According to the IRS, a recharacterization involves the reversal of an IRA contribution or a conversion. The most common types of these recharacterizations include the following three forms:

A Traditional IRA that was converted to a Roth IRA
A Roth IRA to a Traditional IRA
A Traditional IRA to a Roth IRA

So what would cause the owner of an IRA to want to reverse a contribution or a conversion?

Recharacterizing Contributions

This can occur for many reasons, since the recharacterization is at the discretion of the IRA holder. That being said, the most compelling reasons include:

Tax Deduction - if an IRA holder originally thought they were eligible for a tax deductible contribution, but later discover they are no longer eligible for a tax deduction. At this point, they may decide to take advantage of the benefits of a Roth IRA by recharacterizing the Traditional IRA contribution as a Roth contribution. In the same way, an IRA holder may have made a Roth IRA contribution, then later decides to take advantage of a tax deduction and recharacterizes the Roth IRA as a tax deductible Traditional IRA.
Eligibility - the IRA holder might originally believe they are eligible to make a Roth IRA contribution, but later realizes their income was too high to be eligible for a Roth IRA. Here again, the IRA holder might decide to recharacterize the Roth IRA contribution as a Traditional IRA. Eligibility can also apply to conversions, whereby an IRA holder realizes they are no longer eligible to convert a Traditional IRA to a Roth IRA.
Unwanted Conversions - finally, there can be instances where a conversion from a Traditional IRA to a Roth IRA is successful, but the IRA holder realizes the tax burden caused by the conversion is too great. A recharacterization that reverses the conversion can relieve this tax burden.

Recharacterizations versus Conversions

There is a very important difference between a conversion and a recharacterization. Fortunately, the two terms are related:

IRA Conversion - this refers to the rollover or moving of assets from a Traditional IRA, SIMPLE IRA, or other qualified retirement plan into a Roth IRA. There are qualification rules as well as tax implications when converting to a Roth IRA, both of which might prompt the holder to recharacterize the conversion.
IRA Recharacterization - the topic of this particular publication, a recharacterization refers to the undoing, switching, or reversal of an IRA contribution or conversion.

Recharacterization Rules and Deadlines

There are three categories of rules that apply to recharacterizations. These categories include eligible contributions, treatment of net income, and irrevocable elections.

Eligible Contributions - the contributions that are eligible for recharacterizations include conversion contributions, and "standard" contributions to both Roth IRAs as well as Traditional IRAs. Employer contributions and tax-free rollovers are not eligible for recharacterization.
Net Income - when completing a recharacterization, you must include the eligible contribution or conversion plus any net income earned on those dollars in the recharacterization amount.
Irrevocable Elections - once you've decided to recharacterize a contribution or conversion, the change is permanent. You cannot decide at a later date to undo a recharacterization.

The deadline for any recharacterization is the tax return due date for the year of the contribution or conversion. This includes extensions, if permitted. For example, if your deadline for making a 2010 IRA contribution is April 15, 2011, then you have until April 15, 2011 to recharacterize your 2010 tax year contribution.

Recharacterization Example

The calculation of a recharacterization is fairly straightforward. The computation timeline starts when the contribution is made to the IRA, and ends immediately before the recharacterization occurs. The amount recharacterized is always the fair market value of the contribution. Let's see how this works using an example.

In this example, we have a Roth IRA that has a starting balance of $50,000 in June. The holder decides to convert $5,000 of their Traditional IRA to their Roth IRA, resulting in an Adjusted Opening Balance of $55,000. In December, the holder receives an incentive compensation payment, pushing their Adjusted Gross Income (AGI) above the $100,000 Roth IRA contribution threshold. In this case, the holder is no longer eligible to complete the Roth IRA conversion.

In January of the following year, the holder decides to reverse their conversion, recharacterizing the Roth IRA conversion as a Traditional IRA. At the time of the recharacterization, the Roth IRA had a Closing Balance of $60,500. No other funds were transferred into the Roth IRA. During the recharacterization, both the conversion dollars ($5,000) as well as earnings must be moved back to the Traditional IRA. The recharacterization amount is the sum of the conversion to be reversed ($5,000) plus the Net Income on those funds. Net Income is calculated as:

Net Income = Amount to Recharacterize x ((Closing Balance - Adjusted Opening Balance) /Adjusted Opening Balance)

Net Income = $5,000 x (($60,500 - $55,000) / $55,000)
Net Income = $5,000 x ($5,500 / $55,000) = $500

Therefore, the Recharacterization Amount is calculated as:

Recharacterization Amount = Amount to Recharacterize + Net Income
Recharacterization Amount = $5,000 + $500 = $5,500

Recharacterization Calculator

If you need to estimate the recharacterization amount on a conversion or contribution, then you can use our free online Recharacterization Calculator. As is the case with all matters involving the payment of taxes, it's always a good idea to first get assistance from a trained tax professional.

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