For a variety of reasons, it's sometimes necessary to recharacterize an IRA. One of the more common scenarios occurs when an individual 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 contribution.
In this article, we're going to talk about IRA recharacterizations. As part of that discussion, we'll first talk about the different types of these transactions 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 calculator.
According to the IRS, a recharacterization involves the reversal of an IRA contribution or a conversion. The most common types of these transactions include the following three forms:
What would cause the owner of an IRA to want to reverse a contribution or a conversion?
Although these transactions are at the discretion of the IRA holder, the most compelling reasons include:
There is a very important difference between a conversion and a recharacterization. Fortunately, the two terms are related:
There are three categories of rules that apply to this type of transaction. These categories include eligible contributions, treatment of net income, and irrevocable elections.
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 the deadline for making a 2017 IRA contribution is April 15, 2018, then the taxpayer has until April 15, 2018 to recharacterize their 2016 tax year contribution.
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 is always the fair market value of the contribution. Let's see how this works using an example.
A Roth IRA has a starting balance of $50,000 in June. The holder decides to convert $5,000 of their Traditional IRA to their Roth, 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 amount involved 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)
= $5,000 x (($60,500 - $55,000) / $55,000)
= $5,000 x ($5,500 / $55,000) = $500
Therefore, the Recharacterization Amount is calculated as:
= Amount to Recharacterize + Net Income
= $5,000 + $500 = $5,500
Anyone that needs to estimate the recharacterization amount on a conversion or contribution 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.
About the Author - IRA Recharacterization (Last Reviewed on October 19, 2016)