At some point, you may want to recharacterize an Individual Retirement Account (IRA) contribution to change its original designation, either to correct a mistake or because you changed your mind. In other words, you can redefine a Roth IRA contribution as a traditional IRA contribution, or vice versa.
For example, if you made a Roth IRA contribution and then realize that your income exceeds the limits for a Roth account, you can recharacterize it as a traditional IRA contribution
Or you may discover that you don’t qualify for the deduction for your contribution to a traditional IRA because you’re covered by a retirement plan at work. Then you can change it to a Roth IRA contribution, with earnings accruing tax-free.
Here’s a look at how recharacterizations work – and the formula for calculating income and losses, if you’re curious about how the math works.
Key learning points
- You can recharacterize the current year’s individual retirement account (IRA) contributions from a traditional IRA to a Roth IRA, or vice versa. You must make the change before that year’s tax deadline.
- When you recharacterize an IRA contribution, you must remit the contribution plus any income associated with it.
- You can convert the entire balance of your traditional IRA to a Roth IRA at any time by completing a Roth IRA conversion.
- Before the Tax Cuts and Jobs Act (TCJA) of 2017, you could recharacterize (or reverse) a Roth IRA conversion to a traditional IRA.
- Roth IRA conversions are now irrevocable, so you can no longer recharacterize a conversion.
How an IRA Recharacterization Works
To recharacterize a contribution, move the assets from the IRA that received the contribution first to the IRA where you want to keep the assets. Some financial institutions handle recharacterizations simply by switching the IRA from one type to another. Please contact your IRA custodian/administrator regarding the procedure and any documentation requirements for processing a recharacterization.
Deadline to Recharacterize IRA Contributions
The deadline for recharacterizing an IRA contribution is the tax filing deadline for that year, including any extensions you qualify for. That is, if you file your tax returns on time (usually before April 15) and file a six-month extension, your deadline for recharacterizing a contribution is October 15 of that year.
To receive an automatic six-month renewal, you must file Form 4868 electronically or on paper with the Internal Revenue Service (IRS) before filing your tax return. If you submit an electronic declaration, you will receive an electronic confirmation as soon as you have completed the transaction.
Roth IRA Conversions
You can convert the entire balance from a traditional IRA to a Roth account through a Roth IRA conversion.
Doing so could result in a hefty tax bill: you will owe ordinary income tax on the full converted amount at your current tax rate. Still, it could be worth it if you expect to be in a higher tax bracket in retirement than you are now and want to get the taxes out of the way.
The best time to do a Roth IRA conversion is when your income is unusually low or a market downturn has taken a significant bite out of your traditional IRA.
In the past, you could change your mind and recharacterize that Roth conversion to a traditional IRA. However, the Tax Cuts and Jobs Act (TCJA) of 2017 prohibited recharacterizing the account balance from a Roth conversion back to a traditional IRA. Roth IRA conversions are now irrevocable.
Calculate recharacterization gains and losses
Taxpayers recharacterizing their IRA contributions may face the daunting task of calculating their income or losses if their IRA provider does not provide such services.
Correctly calculating income or losses is just as important as the recharacterization itself. The IRS provides a special formula for calculating income or losses on the recharacterized amount. Here’s the formula:
The calculation period begins immediately before the contribution being recharacterized is made to the IRA and ends immediately before the contribution is recharacterized. If the IRA is not valued daily, the most recently available fair market value prior to the contribution can be used as the beginning of the period, and the most recently available fair market value prior to the recharacterization is the ending period.
For example, suppose an IRA is not valued daily and the owner receives account statements monthly. If the owner were to recharacterize a contribution in March 2022 and the contribution occurred in December 2021, the owner would use the November 2021 month-end value of the November statement as the initial period (market value) and the February 2022 monthly statement as the final fair market value.
Sample IRA Recharacterization Calculation
Jack contributed $1,600 to his traditional IRA on December 1, 2020. Before the contribution, his traditional IRA balance was $4,800. In April 2021, when he filed his tax return, Jack realized that he could only deduct $1,200 from his tax return. Unable to deduct the remaining $400, Jack decided to put that amount into a Roth IRA, in which income grows tax-free — unlike income in a traditional IRA, which grows on a tax-deferred basis.
To treat the $400 as a Roth IRA contribution, Jack must recharacterize the amount to his Roth IRA and include any income (or subtract any losses) on the $400. The value of Jack’s traditional IRA when he puts the $400 in April features again is $7,600. No other contributions were made to the IRA and he received no distributions from it. Jack calculates the profit and loss as follows:
The calculation for full recharacterization
The $400 contribution earned $75 during the calculation period. Jack therefore needs to recharacterize $475 ($400 + $75) for his Roth IRA. For tax purposes, the $400 is treated as if it came with the Roth IRA from the start.
A profit or loss calculation is only required in the case of a partial recharacterization. In other words, if the entire IRA balance is recharacterized, no calculation is required.
For example, suppose you created a new Roth IRA and funded it with $3,000 in January 2020. In October 2020, the IRA earned $500, bringing the balance to $3,500. To claim a deduction for the $3,000, decide you want to treat the amount like a traditional IRA contribution. Because the Roth IRA received no other contributions or made any distributions — and because the IRA had no balance before the $3,000 contribution — you can recharacterize the entire balance back to the traditional IRA.
Tax return forms
Your IRA custodian will report your IRA contributions (to both you and the IRS) on IRS Form 5498. A contribution is reported even if it is later recharacterized. If you characterize your contribution again, you will receive two Forms 5498: one for the first contribution and a second for the amount that will be credited to the other IRA as characterization.
You will also receive a Form 1099-R for the IRA that received the contribution first. Form 1099-R is used to report distributions from retirement accounts. Your custodian uses a special code in box 7 of Form 1099-R to indicate that the transaction is a recharacterization and therefore not taxable.
Partial recharacterizations must be reported on IRS Form 8606. Form 8606 is filed with your tax return, but you do not need to file Form 8606 for full recharacterizations.
How Can I Recharacterize an IRA Contribution?
To recharacterize the contribution of an individual retirement account (IRA), you must have another IRA — existing or new — to accept the funds withdrawn.
Notify your financial institution(s) that you wish to recharacterize a contribution. If the same IRA provider maintains both IRAs, you can notify only that institution. Otherwise, you’ll need to contact the custodian that has the initial IRA contribution and the institution that will accept the recharacterized contribution.
You can generally do the recharacterization online or by using standard forms provided by the IRA custodian(s).
You must report the recharacterization on your tax return for the year in which you made the original contribution, using IRS Form 8606.
How Much Can I Contribute to an IRA in 2022 and 2023?
For the 2022 tax year, you can contribute up to $6,000 to Roth and traditional IRAs, plus a $1,000 catch-up contribution if you’re 50 or older. That’s the combined maximum for all of your IRAs. So, for example, if you add $4,000 to your traditional IRA, the most you could contribute to a Roth in the same tax year would be $2,000 (or $3,000 for those 50 and older).
For the 2023 tax year, the limits will increase to $6,500. The catch-up contribution remains at $1,000.
Can I Recharacterize a Roth IRA Conversion in 2022?
No. The rules have changed. You can no longer recharacterize a Roth IRA conversion. Once you convert a traditional IRA to a Roth IRA, the move cannot be reversed.
It comes down to
Failure to accurately calculate and report a characterization can get you in trouble with the IRS. If in doubt, consult a competent tax specialist for help in making the right choices and reporting them correctly.
Also, be sure to submit your recharacterization instructions to your Roth IRA custodian before the deadline.