The Recharacterization: A Valuable Tool in Your IRA Kit

By Sarah Brenner, IRA Technical Expert
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Recent weeks have been volatile times for the markets. In times of economic uncertainty, tools that allow you a “do over” are more valuable than ever. As an IRA owner, you have such a tool in your IRA tool kit. A recharacterization is a tax-free transfer of funds from one kind of IRA to another. If you converted a traditional IRA to a Roth IRA and now are reconsidering, recharacterization allows you to undo the transaction and move the funds back to a traditional IRA. You can also recharacterize a tax-year traditional IRA contribution from a traditional IRA to a Roth IRA or vice versa.

You may consider recharacterizing for many reasons. If you converted your traditional IRA to a Roth IRA, you might have be having second thoughts about the tax bill. Another possibility with the current market swings is that you may have converted when the value of your traditional IRA was much higher. Now the funds are in a Roth IRA and have lost value. You have the option of recharacterizing those funds. You can choose to recharacterize the whole conversion or just a portion.

However, if you recharacterize just part of your conversion, you may not select the investments you want to recharacterize, only the dollar amounts. Be aware also that there are restrictions on reconverting after a recharacterization. You may not reconvert the same funds until the beginning of the next taxable year following the year of the conversion, or if later, more than 30 days from the date of the recharacterization. Deciding whether recharacterizing a conversion is the right plan for you can be complicated. If you are considering this option, consult with an advisor who is an expert in this area.

Recharacterization is also a valuable for tax-year contributions. Maybe you contributed to a traditional IRA and later discovered the contribution was not deductible or maybe you contributed to a Roth IRA not knowing that your income was above the eligibility limits. You may recharacterize the nondeductible traditional IRA tax-year contribution to a Roth IRA and have tax-free instead of tax-deferred earnings if your income is within the Roth IRA contribution limits for the year. Or, if your Roth IRA contribution is an excess contribution because your income was too high, you may recharacterize that contribution to traditional IRA because there are no income limits for traditional IRA contributions.

If you have decided that a recharacterization is a good move for you, contact your IRA custodian. You will need to provide the custodian with some information to conduct the transaction such as the amount you would like to recharacterize and the date of the contribution or conversion. Most IRA custodians can provide you with a form to collect all the necessary information to complete a recharacterization. The IRA custodian will then directly move the funds you choose to recharacterize, along with the earnings or loss attributable, from the first IRA to the second IRA. This is a tax-free transaction but both IRAs report the transactions to you and the IRS. You will receive a 2015 Form 1099-R from the first IRA and a 2015 IRS Form 5498 from the second IRA.

The deadline for recharacterizing a 2014 tax-year contribution or conversion is October 15, 2015 for taxpayers who timely file their 2014 federal income tax returns. This is true even if you do not have an extension. You will need to file an amended 2014 federal income tax return if you recharacterize after you have already filed. The deadline for recharacterizing 2015 contributions and conversions is October 17, 2016.