Recharacterization

Recharacterization allows an investor to change the designation from one type of IRA to another. Investors may recharacterize traditional or Roth IRA contributions.

There are a few ways to convert from traditional Individual Retirement Accounts (IRAs) to Roth.

One way is with a "rollover," which means undoing your previous conversion and recharacterizing the funds back as they were before, meaning there is no tax burden on this transaction either way for doing so.

The recharacterization process permitted investors to change the designation and application of certain aspects. This often involves considering tax efficiency.

How Does Recharacterization Work?

The recharacterization process is relatively simple. You fill up and file a form with your custodian (the financial institution where you hold your IRA) indicating that you want to recharacterize a contribution.

You will need to do this by the tax return deadline for the year in question, plus any extensions.

Investors can take two different actions when converting from one type of retirement account to another. A recharacterization reverses the conversion, while a more common option is referred to as an " IRA transfer."

The former involves taking assets or similar types of funds and moving them over into Roth IRAs with pre-tax dollars if you are going forward with this route.

Otherwise, they will go into regular taxable accounts where earnings will ultimately become tax-free once withdrawal time comes.

If you have miscalculated your tax liability for the year, it may be helpful to recharacterize part or all of your contribution.

Recharacterization and Conversions

There are a few things to keep in mind when recharacterizing a conversion:

• It can only be done if your Roth IRA has been open for less than a year.
• If you recharacterize part of your contribution, you cannot reconvert that portion for at least 30 days.
• You will need to report it on two different tax forms.  Form 1099-R provides information about distributions from these accounts while; Form 5498 is used for tracking contributions.
  
  

The following are the retirement accounts that you can convert to Roth IRA:

• 401(k) plan from a former employer
• 403(b) plan from a former employer
• 457(b) plan from a former employer
• Traditional IRA
• Rollover IRA
• SEP IRA
• SIMPLE IRA
• SARSEP IRA

Prohibited Transactions

There are a few types of transactions that are not allowed in Roth IRAs:

• Withdrawals before age 59 ½. You will owe a penalty of ten percent, plus any taxes due on the withdrawal.
• Excess contributions. You will owe a six percent penalty on the amount over the limit, plus any taxes due.
• Contributions to a Roth IRA when you earn too much money. Your income must be below certain limits to contribute to a Roth IRA.

Why or Why Not Choose Recharacterization?

Recharacterization can be a helpful way to change how certain assets are treated. This is often done to take advantage of tax benefits, and it does have its pros and cons:

The Bottom Line

Recharacterization is a way of undoing a Roth IRA conversion. This can be helpful if you have miscalculated your tax liability for the year.

However, it is important to note that this option is only available if your Roth IRA has been open for less than a year. You are also allowed to recharacterize part or all of your contribution.

And if you recharacterize part of your contribution, you cannot reconvert that portion for at least 30 days. Finally, few types of transactions are not allowed in Roth IRAs.

It is important to understand how it works before making any decisions. For more information, consult with a financial advisor.

FAQs

1. Is a recharacterization taxable?

It depends on the amount recharacterized. If you recharacterize part of your contribution, you will not owe taxes on that portion. You may owe taxes on the recharacterized amount if you recharacterize a conversion.

2. Can you convert a recharacterization?

You can convert your recharacterized assets, but it will take time, and you have to wait until the year following or more than 30 days after converting them, whichever comes later for this reconversion process.

3. How do I report recharacterization on my tax return?

You will need to report it on two different tax forms. Form 1099-R provides information about distributions from these accounts while; Form 5498 is used for tracking contributions.

4. Are earnings on Roth recharacterization taxable?

The IRS does not tax your before-tax earnings since they were simply switched into a recharacterized account. That is the only way to prepare and attach an explanation statement for these transactions.

5. How do I report Roth IRA recharacterization on a tax return?

When you recharacterize your Roth IRA contribution, do not report it on Form 8606. Attach a statement to the return explaining the recharacterization.