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Recharacterizing IRA Contributions and Roth Conversions



Did you know you may be able to "undo" or recharacterize regular (i.e., non-rollover) IRA contributions? In effect, you get to treat a contribution to one IRA as having been made directly to a different IRA.

What is a recharacterization?

A recharacterization is an election to change the nature of your IRA contribution. The opportunity to recharacterize a contribution from one IRA to another type of IRA is designed to help taxpayers who change their minds or are ineligible for one type of IRA and want to switch to another. Generally, you may recharacterize (correct) an IRA contribution by making a trustee-to-trustee transfer of the contribution (plus any related earnings) from one IRA to another type of IRA within certain deadlines.

When an individual recharacterizes an IRA contribution, the contribution is treated as though it had never been made to the original IRA; rather, the contribution is treated as having been made (as of the date of the original contribution to the original IRA) to the IRA to which the recharacterized funds are transferred.

How do recharacterized earnings and losses affect normal IRA contribution limits?

The amount recharacterized from one IRA to another must include related earnings or be reduced by any loss. However, earnings that are transferred with a recharacterized contribution don't affect the otherwise maximum IRA contribution limit.

Assume John contributes $1,000 to his traditional IRA for 2019. Before the deadline for filing his 2019 federal income tax return, John decides to recharacterize his contribution (plus the $50 in earnings allocable to it) to a Roth IRA. Through a trustee-to-trustee transfer, $1,050 is switched to his Roth IRA. If John is otherwise eligible, he can contribute an additional $5,000 ($6,000 if he is age 50 or older by the end of the tax year) to his Roth IRA for 2019. The $50 of earnings is treated as having been earned in the Roth IRA.

Similarly, losses attributable to a recharacterized contribution don't increase the contribution limit to the second IRA.

How do you recharacterize an IRA contribution?

To recharacterize an IRA contribution, you should take the following steps:

Establish another IRA (if necessary)

Generally, you'll either need to establish an IRA or use an existing IRA to accept the withdrawn IRA funds. Recharacterizations made with the same IRA trustee can (if the trustee permits) be made by redesignating the first IRA as the second IRA (assuming the IRA is composed only of the contribution and earnings that you want to recharacterize), rather than transferring the account balance to a new account.

You can't recharacterize employer contributions (including your elective deferrals) under a SEP-IRA or SIMPLE IRA plan as contributions to another IRA.

Inform both financial institutions that you want to recharacterize

If more than one financial institution is involved, you must notify both financial institutions — the one servicing your present IRA and the one that will accept the recharacterized money — that you intend to effect a recharacterization. (Only one notification is required if both IRAs are maintained by the same trustee.) Transferring your money without such a notice may invalidate the recharacterization. You must provide the notice on or before the date of the transfer.

A valid recharacterization of IRA assets generally must be accomplished through a direct (either trustee-to-trustee or custodian-to custodian) transfer. You can't withdraw money from your IRA and roll it over to a new IRA within 60 days — the assets must be transferred directly from one IRA to the other.

In most cases, you can recharacterize your contribution online, or by using your IRA provider's standard form. In the unlikely event your IRA provider doesn't have a standard form for recharacterizations, you should consult a tax professional to create one. Your form should include all required information, including the following:

  • An appropriate heading, such as "Notice of Election to Recharacterize IRA Contribution."
  • Your name, address, telephone number, IRA account number, and Social Security number.
  • The name of the first IRA trustee and the name of the second (new) IRA custodian/trustee.
  • The type and amount of the contribution to the first IRA that you now want to recharacterize. Inform the first IRA trustee that you want your contribution plus any net income (or net loss) allocable to that contribution to be recharacterized. (See below for more information on calculating net income/loss.)
  • The date on which the contribution was made to the first IRA, and the year for which it was made (if applicable).
  • A direction to the first IRA custodian/trustee that you want to make a direct, trustee-to-trustee/custodian-to-custodian transfer of funds from your present IRA to a new IRA by a specified date. (Include the account number of the new IRA, as well as the name, address, and telephone number of the new IRA custodian/trustee.)

Send a copy of your recharacterization notice to both IRA custodians/trustees. In addition, you should follow up with both of them to ensure that the transfer is accomplished on time.

Meet all applicable deadlines

The deadline for recharacterizing an IRA contribution is the due date of your federal income tax return, including extensions, for the year of the original contribution. (The year of the original contribution means the year to which the contribution relates — not the year the contribution was actually made.) So, if you file for an automatic extension, you have until October 15 to recharacterize a contribution for the preceding year.

You can use this special procedure only if you filed your income tax return on time (i.e., either by April 15, or within the extension period if you filed for an extension in a timely manner).

Don't confuse the amended return date with the recharacterization due date. An amended return can be filed as late as three years after the original return was filed.

Report the recharacterization

If you elect to recharacterize a contribution (either on your federal income tax return or on an amended return), you may have to attach Form 8606 and a statement explaining the recharacterization. You must report the recharacterization on the tax return for the tax year in which you made the original contribution. See the instructions to Form 8606 for more information.

How do you allocate the earnings when you recharacterize a contribution?

When you recharacterize an IRA contribution, you must transfer the contribution plus any earnings allocable to that contribution to a new IRA.

Full recharacterization

If your IRA is composed only of the contribution and earnings that you want to recharacterize, you can simply recharacterize (transfer) the entire IRA. If your IRA has suffered a loss since the time of the original conversion, you don't have to make up the loss when you recharacterize the IRA.

Partial recharacterization

If you're recharacterizing only part of an IRA, you need to determine how much of the IRA's earnings are attributable to the part you're transferring and how much belong to the portion of the IRA that remains. Here's the formula (note that net income can be negative):

Net income = Contribution x [(Adjusted closing balance - Adjusted opening balance) / Adjusted opening balance]

The opening balance for this computation is the IRA's fair market value (FMV) immediately before the contribution was made to the account, and the closing balance is the FMV of the account right before the contribution is removed. The "adjusted opening balance" is the opening balance plus any contributions or transfers (including the amount being recharacterized) made to the account during the computation period. The "adjusted closing balance" is the closing balance plus any distributions (including recharacterizations) made from the account during the computation period.

If more than one contribution is being recharacterized, different rules may apply. If multiple contributions for a particular year are eligible for recharacterization, the IRA owner chooses which contribution to recharacterize. And if a series of regular contributions had been made, and consecutive contributions in that series were being recharacterized, the computation period would be determined using a single computation period (based on the first contribution in the series). For more information, consult a tax professional.

Your IRA provider may calculate for you the amount of net income to be transferred. If your provider is unable to do so, direct him or her to IRS Notice 2000-39 and IRS Reg. Section 1.408A-5.

Securities offered through Regulus Advisors, LLC. Member FINRA/SIPC. Investment advisory services offered through Regal Investment Advisors, LLC., an SEC Registered Investment Advisor. Regulus Advisors, Regal Investment Advisors, and Regal Financial Group are affiliated entities. This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2020