IRA Recharacterization

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.

Recharacterizing an IRA

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:

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

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

Reversing IRA Conversions and Contributions

Although these transactions are at the discretion of the IRA holder, the most compelling reasons include:

  • Tax Deduction:  if an account owner 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 account owner may have made a Roth contribution, then later decides to take advantage of a tax deduction and recharacterizes the Roth IRA as a tax deductible Traditional IRA.
  • Eligibility:  the account owner 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 contribution.  Here again, the IRA holder might decide to recharacterize the Roth contribution as a Traditional IRA.  Eligibility can also apply to conversions, whereby an account owner 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 account owner 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, both of which might prompt the holder to recharacterize the conversion.
  • IRA Recharacterization:  the topic of this particular article, this refers to the undoing, switching, or reversal of an IRA contribution or conversion.

Rules and Deadlines

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.

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

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.

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 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

Online Calculator

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)