IRA recharacterization

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.

How to Recharacterize
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.

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.

Links

 * Fairmark's Roth IRA Guide: Recharacterizations
 * IRS Publication 590, IRAs
 * Recharacterizing Your IRA Contribution or Roth Conversion Denise Appleby, Investopedia