By Andy Ives, CFP®, AIF®
As we enter tax season and consider last year’s transactions, it bears repeating: Roth IRA contributions can be recharacterized, Roth conversions cannot.
A Roth IRA contribution can be recharacterized (changed) to a Traditional IRA contribution. The opposite is also true. A Traditional IRA contribution can be recharacterized to a Roth contribution. This can be done for any reason. As long as the recharacterization is done by October 15th of the year after the contribution, it is a perfectly acceptable transaction in the eyes of the IRS. The original contribution and associated earnings will appear to have gone to the proper account from the very beginning. Do not overlook the value of this tool.
Why would someone want or need to recharacterize an IRA contribution? Maybe they contributed to a Roth IRA, but then realized they were over the Roth IRA contribution limits ($196,000 – $206,000 for joint filers in 2020; $124,000 – $139,000 for single). Maybe they contributed to a Traditional IRA, but later discovered they could not deduct the contribution due to their income level and participation in a work plan like a 401(k). In such a case a Roth IRA could make more sense.
Regardless of the reason for the change, know that the excess contribution or deposit into the “wrong” type of IRA can be corrected with recharacterization. An excess contribution withdrawal is not the only fix. However, if the decision is made to actually remove the unwanted contribution as an excess, the contributed amount plus the net income attributable (NIA) must be withdrawn (if processed before the deadline). There is a worksheet in IRS Publication 590-A that can help calculate the NIA. To avoid both the 6% excess penalty and the need to file Form 5329, be sure the excess plus NIA is withdrawn by October 15 of the year after the excess contribution, and that the distribution is properly coded.
Recharacterization of a contribution sure sounds a lot easier, doesn’t it? Plus, a person gets to keep their money in an IRA, regardless of the type of IRA.
Example: Max, age 30, is eager to start saving for retirement. He has never had an IRA before, and proudly contributes $6,000 to a Roth IRA. Max loves the idea of tax-free growth. Sadly, he learns a few months later that his high income disqualifies him from contributing to a Roth IRA directly. Max seeks the advice of a financial advisor who informs Max that all is not lost. The advisor recommends that Max recharacterize the Roth IRA contribution to a non-deductible Traditional IRA contribution.
Max agrees, but he had his heart set on a Roth IRA. Fortunately, Max’s advisor is on the ball. She tells Max that after the recharacterization to a non-deductible Traditional IRA, they will file Form 8606 to claim the basis. They will then do a Backdoor Roth conversion to get all those dollars into the Roth IRA. Since Max has no other IRA, SEP or SIMPLE plans, the pro-rata rule says this will be a largely tax-free conversion. (Max will have to pay the conversion taxes on the small amount of earnings on his original $6,000.) Regardless, Max is ecstatic.
Recharacterization of an IRA contribution. Still an important tool in the toolbox!