IRA recharacterization

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If you made a conversion of a traditional IRA to a Roth IRA, or contributed to either one, you can switch the type of IRA by doing a recharacterization through October 15 of the year after you made the original conversion or contribution. The recharacterization allows you to treat the conversion as if it never happened, or the contribution as if it was made to the correct type of IRA in the first place. You can use it to save on taxes, or to correct a contribution that you discovered later you were not allowed to make. The most common tax saving occurs if you converted a traditional IRA to a Roth, and then the value of the Roth declined significantly.


Imbox notice.png To clarify the timing of conversions and recharacterization, keep in mind that conversions must be made within a calendar year. For example between January 1 and December 31, 2012. The tax on this conversion will be due on the April 15, 2013 tax filing date. The conversion can be recharacterized up to the October 15, 2013 six-month extension period that the IRS grants taxpayers.

If you recharacterize a conversion, you cannot re-convert the same money in the year of the original conversion, nor within 30 days after the recharacterization. See the quote box below for an extended illustration.


How to recharacterize

Time Line for Converting to a Roth IRA and then Recharacterizing Back to a Traditional IRA

"What follows is a potential timeline for the conversion and recharacterization process.

Year One

Make a conversion before year end. Please note that many brokerage houses need at least a week and sometimes longer to process the paperwork. Therefore, I would consider the practical deadline to be about December 15 of Year One to make the conversion.

As a practical matter, however, for the maximum “look-back” period, you would want to convert at the beginning of the year as opposed to the end of the year. Therefore, if all other factors are the same, you may want to consider waiting from December, for example, until January to make the conversion. This small wait gives you an additional 11 months or so of hindsight.

Year Two

April 15: File your first extension for your Year One tax return if you want more time to decide on your Year One conversion. As noted above, you can file your return if you are ready and still take advantage of the six-month additional period to make the recharacterization, but you must be prepared to execute the transfer and file an amended return by October 15.

October 15: This is the final deadline to “unconvert” undesirable Year One conversions and file by the close of the “automatic” extension period.

November 16: This is the first opportunity for you to reconvert your recharacterized traditional IRA. (You could do this earlier if the recharacterization was done earlier than the October 15th deadline.)

December 15: This is the last chance for initiating additional Roth conversions for Year Two, assuming 16 days are needed to accomplish them.

This timeline does not project beyond Year Two, but barring other tax law changes, the same logic would continue to apply for future years."

-- Roth IRA Conversions-An Aggressive Strategy by James Lange, JD, CPA


For details, see IRS Publication 590.

To make a recharacterization, notify the trustee of the IRA (Vanguard, for example) which transaction you want to recharacterize. The amount which is recharacterized includes any earnings or losses on the IRA since the contribution; your trustee can usually compute the earnings for you and transfer the proper amount to the new IRA. However, for tax purposes, it is treated as if the original amount were contributed; for example, if you contributed $5000 to a Roth IRA, the Roth IRA declined in value to $4000, and you recharacterize the contribution as a Traditional IRA contribution and are eligible for a deduction, you may deduct $5000 as an IRA contribution for the year.

If you filed your tax return by April 15 of the year following the contribution (or applied for an extension at the time), you may recharacterize until October 15 of that year. If you recharacterize after April 15, write "Filed pursuant to section 301.9100-2" on your amended return.

The recharacterization will change your taxes for the year of the original contribution, even if you recharacterized in the following year. If you have already filed a tax return for the year of the contribution, you must file an amended return. If you undid a conversion, or recharacterized a Roth IRA contribution as a deductible IRA contribution, you will receive a refund. If you recharacterized a deductible IRA contribution as a Roth IRA contribution, you will owe extra tax. If you recharacterized a non-deductible IRA to a Roth IRA or vice versa, your tax owed will not change, but you still need to amend the return to correct your IRS Form 8606, Nondeductible IRAs.

If you recharacterize a conversion, you cannot re-convert the same money in the year of the original conversion, nor within 30 days after the recharacterization.

How to save taxes by recharacterizing

Market declines after conversion

If the value of your IRA decreases after a conversion, you can recharacterize the conversion, avoiding the tax on the original conversion, and then convert the IRA at a lower value for a lower tax bill. This is the most common way to save taxes with a recharacterization.

Example: You converted a $10,000 IRA to a Roth in April 2008, and expected to pay $2500 tax on the conversion because you were in a 25% tax bracket. In March 2009, your Roth has lost 40% of its value since the conversion. You recharacterize the conversion, and no longer owe any tax on it for 2008, leaving you with $6000 in the original IRA. In April 2009 (at least 31 days later), with the IRA now worth $7000, you convert it again; you will owe $1750 in taxes for 2009 on the conversion, saving $750 in taxes.

Converting exactly to the top of a tax bracket

You can recharacterize part of a conversion, and use this to optimize by spreading your conversion over multiple years, doing it all in the same tax bracket. You convert the most you could expect to be able to convert in the lower bracket, and then once you find the bracket you are actually in, you recharacterize the part of the conversion that would be in a higher tax bracket, postponing it until a future year when you expect to convert it in a lower bracket.

Example: You converted a $20,000 IRA to a Roth in October 2009. In March 2010, while doing your 2009 taxes, you found that you could convert $12,000 in the 15% tax bracket but anything above that would be in the 25% bracket. You recharacterize $8000 of the conversion, and thus owe $1800 rather than $3800 in taxes. In April 2010 (at least 31 days later), you convert it again, expecting to be in the 15% tax bracket for 2010. If the account is still worth $8000, you pay $1200 in taxes and save $800; even if it has grown to $10,000, you pay $1500 in taxes and save $500.

Changing type of IRA contribution

If you contributed to a deductible IRA and its value rose, you can benefit by recharacterizing rather than converting directly to a Roth. If you converted to a Roth IRA and its value fell, you can benefit by recharacterizing if you are eligible for a traditional IRA.

Example: You contributed $5000 to a deductible Traditional IRA in March 2009, and expected to reduce your taxes by $1250 because you were in a 25% tax bracket. In January 2010, with the Traditional IRA now worth $7000, you decide that a Roth IRA would be better. If you convert the Traditional IRA to a Roth, you would get a $1250 tax reduction for 2009 but owe $1750 for 2010. If you recharacterize the 2009 contribution as a Roth contribution, you save $500 in taxes.

Example: You contributed $5000 to a Roth IRA in April 2007 even though you were eligible for a deductible IRA. In October 2008, your Roth has lost 40% of its value. You recharacterize the contribution as a Traditional IRA contribution, filing an amended return, and receive a $1250 refund because you are are in a 25% tax bracket, and $3000 in the Traditional IRA. You wait until January 2009 in order to postpone taxes for another year, then convert the Traditional IRA, which is still worth $3000, back to a Roth IRA; you will owe $750 in taxes for 2009 on the conversion, saving $500 in taxes.

Different tax brackets

If you can undo a taxable conversion or contribution and redo it in a year in which you are in a lower tax bracket, you may benefit even if the market does not move.

Example: You converted a $10,000 IRA to a Roth in July 2008, paying $2500 tax because you were in a 25% tax bracket. In August 2009, the Roth is still worth $10,000, but you realize that you will be in a 15% tax bracket for 2009 even if you add $10,000 to your income. You file an amended 2008 return and get the $2500 back. In September 2009 (at least 31 days later), you reconvert the IRA, which is still worth $10,000, and will owe only $1500 in tax on the conversion for 2009, saving $1000 in taxes.

Missing the deadline

The IRS will consider relief for taxpayers who belatedly discover that they are ineligible for making a conversion, especially when these are errors made in good faith, and are reported prior to the IRS uncovering the error (under Reg.301.9100-1)[1].

Furthermore, both the Congress and the IRS sometimes grant extensions for disaster relief for victims of disasters. [2]

References

  1. 26 CFR 301.9100-1 - Extensions of time to make elections, Legal Information Institute, Cornell University Law School.
  2. Choate, Natalie, Life and Death Planning for retirement plans, sixth edition, 2006, pp. 255-256.

External links