Recharacterization

What is Recharacterization?

Now that you have made your IRA contribution or even performed a Roth IRA conversion, you should know that you have options to undo these decisions if the need should arise.  The IRS provides us with the flexibility to alter our IRA contribution or conversion decisions through a recharacterization

A Roth IRA recharacterization allows you to reclassify your IRA contribution, or conversion, from a Roth IRA back to a traditional one.  The question you are probably asking is why would someone want to do this?  There are a variety of reasons for which one would recharacterize their IRA.  In the rest of this article, we will discuss the rationale behind a recharacterization and also discuss a few of the rules that surround it.

Rationale behind Recharacterization

Modified AGI Exceeds Roth IRA limits

This issue tends to pop up for individuals who do not have a fixed yearly salary; or work on commission or other forms of variable pay.  What if you contribute to a Roth IRA, or convert your traditional IRA to Roth, and then realize at the end of the year that you exceeded the Roth income threshold?  The Roth recharacterization allows you to transfer the funds back into your traditional IRA and avoid paying any taxes or penalties on the amount.  There is a time limit on this and we will cover this a bit later. 

For Roth conversions, this issue will become a non-issue in 2010 when the income cap of $100,000 to convert will be lifted. 

Market Malaise Hits Your Account Value

This applies more to a Roth IRA conversion, and the market collapse in 2008 clearly illustrates this point.  If you made a Roth conversion early in the year for $50,000 and then watched the account shrink to $25,000 during the crash, the Roth IRA recharacterization will become your best friend.  Rather than including the $50,000 as income on your tax return (and subsequently paying tax on it), you can transfer the funds back to the traditional IRA before the deadline and then reconvert at a later date.

Unintended Consequences

Some of you will also realize later in the year that you may not earn enough income to pay the taxes associated to the Roth conversion.  Additionally, as we covered in our Roth IRA contribution lesson, you need to be very careful in how much income you show on your tax return if you have children in college and you need to apply for financial aid.  For this reason alone, many will be forced into a Roth recharacterization.

Recharacterization Rules

We discussed a few of the reasons why someone would recharacterize their Roth IRA; now, let’s review some of the guidelines that you must follow in order to successfully perform an IRA recharacterization.

A recharacterization from a Roth to a traditional IRA must be made through a trustee to trustee direct transfer.  This means that your IRA administrator will either have to convert your Roth IRA account to traditional or create a new account and move the funds.  When you recharacterize funds, you must not only transfer the contributed amount, but also any investment gains which were made in the account as well.  You will have until October 15th of the year following the tax year to perform this transfer, in order to avoid any taxes or penalties.  As long as you meet the deadline, your contribution and investment gains will be treated as if they had been made in the traditional IRA. 

In the case of a Roth IRA conversion gone badly, as we explained above, the same rules apply for recharacterization as they did from above; however, there are waiting periods before one can reconvert the traditional into a Roth IRA for a second time.  These waiting periods were put into place to prevent savvy investors from abusing the policy by converting and recharacterizing multiple times throughout the year to take advantage of pullbacks in the market.  If the market moved lower, they aimed at showing the lowest possible taxable conversion amount on their tax returns.

Reconversions can only be done in the subsequent tax year or after 30 days, whichever is longer.  For example, a recharacterization on September 1 would be available for reconversion on Jan 1 of the following year while a recharacterization on December 15 would be available for reconversion again on Jan 14 of the following year.  Violating these rules would result in a “failed conversion” and make you liable for paying taxes and all applicable penalties.


<< Part 1 - Roth IRA Overview
<< Part 2 - Roth IRA Contribution
<< Part 3 - Roth IRA Conversion
<< Part 4 - Roth IRA Withdrawal
<< Part 5 - Distribution Ordering Rules
Tim Ord
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