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George F. Bearup, J.D. Senior Legal Trust Advisor

3-Mar-21

Refresher on Roth IRA Recharacterizations

Take-Away: Roth IRA contributions can be recharacterized, or changed, to a traditional IRA contribution. However, Roth IRA conversions can no longer be recharacterized back to a traditional IRA. Roth contributions vs. Roth conversions can ultimately lead to confusion.

Background: A Roth IRA contribution can be recharacterized, or changed, to a traditional IRA contribution. Similarly, a traditional IRA contribution can be recharacterized, or changed, to a Roth IRA contribution. No reason, or permission, is required for either recharacterization.

  • October 15 Deadline: The only requirement is that the IRA recharacterization must be completed by October 15 of the year after the year in which the IRA contribution is made.
  • Earnings Also Must be Recharacterized: Both the original contribution to the IRA and the earnings on that contribution, called the net income attributable (NIA), will also have to be transferred to the proper account if there is a recharacterization. The earnings will be computed from the beginning date of the contribution to the IRA. IRS Publication 590-A provides a worksheet that is used to calculate the NIA when earnings are recharacterized from one type of IRA to another type of IRA.

Roth IRA Conversions: Prior to the 2017 Tax Act, a traditional IRA owner could convert their traditional IRA to a Roth IRA. The owner could then convert their Roth IRA back to a traditional IRA (and then recover the income taxes that were paid on original conversion to the Roth IRA) by a specified date. This ability to shift back to the traditional IRA was intended to protect the IRA owner when the Roth IRA account value went down after the Roth IRA conversion when income taxes were paid on the conversion, i.e. the IRA owner paid income taxes on value (due to the drop in market values) that no longer existed. This ability to change a converted Roth IRA back into a traditional IRA and recover the income taxes that had been paid was eliminated a couple of years ago. If a traditional IRA is converted to a Roth IRA, the IRA owner bears the risk that the value of the Roth IRA will drop,  causing the Roth IRA owner to have ‘overpaid’ income taxes on the converted phantom amount.

Why a Recharacterization?: There are several reasons why an individual may want, or need, to recharacterize a contribution to a traditional IRA or a Roth IRA.

  • Earnings Limit for Roth IRA Contributions: An individual contributes directly to a Roth IRA, only to find that his or her earnings for the year were over the Roth IRA contribution limit, e.g. the phase-out of an individual’s ability to contribute to a Roth IRA in 2020 ranged from $124,000 to $139,000 in their reported earnings.
  • Inability to Deduct Traditional IRA Contributions: An individual contributes to a traditional IRA, only to later discover that he or she cannot deduct the IRA contribution due to their income level and their participation in their employer’s 401(k) plan, i.e. a Roth IRA contribution would have been better in hindsight.
  • Avoid the 6% Penalty: If an excess contribution to the IRA results, the 6% excise tax will be imposed by the IRS on that excess amount until the excess contribution to the IRA is removed, through a recharacterization. With an excess contribution the IRA owner will also have to file IRS Form 5329 as part of the ‘fix.’

Example: Judy, age 33, starts to save for her retirement. Judy has not opened an IRA prior to this time. Judy contributes $6,000 to a Roth IRA that she just opened. Judy later learns that her annual income of $142,000 disqualifies her from contributing to a Roth IRA. Judy then recharacterizes her Roth IRA to a non-deductible traditional IRA. Judy files IRS Form 8606 to establish her income tax basis in that traditional IRA account. However, Judy wanted to fund a Roth IRA since she likes the idea of income-tax free distributions and also the fact that there are no required minimum distributions(RMDs) associated with a Roth IRA. Judy then makes a backdoor Roth IRA conversion to move the $6,000 (and its earnings) from her non-deductible traditional IRA into a Roth IRA. Because Judy has no other IRAs (or SEP or SIMPLE IRAs) the IRS’s pro rata rule will result in this backdoor Roth IRA conversion being almost totally a tax-free conversion. Only the earnings Judy had earned on the $6,000 will be subject to immediate income taxation.

Conclusion: There are ways to move funds from traditional IRAs to Roth IRAs, and vice versa. Sometimes the reason is the desire for tax-free growth in a Roth IRA. Sometimes it is when the owner needs an immediate income tax deduction with a contribution to a traditional IRA. Sometimes the reason is simply to address the inability to make a Roth IRA contribution and thus the need to ‘fix’ the problem, or the need to eliminate an excess contribution to an IRA. Whatever the reason, funds can move from one IRA to another IRA without much hassle, so long as the earnings are moved along with the initial contribution, and the October 15 deadline is met. IRA recharacterizations are alive and well and still available.