DR 102: 4 Times Recharacterizing an IRA Conversion or Contribution Can Save Your Bacon (Literally)

One of the best retirement savings tools is often overlooked. The tool can save you thousands of dollars in taxes and sleepless nights if you made a mistake with your IRA. And yet according to a 2010 study by Fidelity less than one-third of investors are aware of this tool. I’m referring to what’s called a “recharacterization” of an IRA conversion or contribution.

We’ll look at exactly how a recharacterization works and situations when it can be your best friend (financially speaking, anyway). But first, here’s an email I received on this topic from a reader named Chintan:

Hi Rob,
I have been a subscriber to your newsletter for a few months and am recently listing to the podcasts. Keep up the great work.

I am 29 years old and have recently started thinking seriously about retirement. I wish I should have started earlier!

I was listening to your podcast about the back door Roth conversion and had a question:

I have an IRA form 2012 and 2013 tax year. In order to get a head start for 2014 tax year I contributed the maximum amount to my IRA in February of 2014. However, I changed jobs in February of 2014 and my income will be above the IRA limit. So I asked my accountant and he informed me that I should take a penalty and take the money out. I did not listen to him and found out from my brokerage at Sharebuilder that I can recharacterize the $5,500 contribution to a Roth IRA. I completed the paperwork for recharacterization in March of 2014 and the amount that was recharacterized was $5,700. Why $5,700 and not $5,500? Is this because they looked at my IRA contributations from the 2012 & 2013 tax year?

I would appreciate your help. Thank you very much

To put this question into some context, let’s first look at recharacterization.

Listen to the podcast of this article

What is a Recharacterization

Recharacterizing an IRA conversion or contribution is like using the “undo” command on your computer. It allows you to undo an IRA conversion or switch an IRA contribution from traditional to Roth or Roth to traditional.

The IRS provides an excellent summary of recharacterizing a Roth Rollover or Conversion. Here are the highlights:

  • A recharacterization allows you to “undo” or “reverse” a rollover or conversion to a Roth IRA.
  • You generally can recharacterize your rollover or conversion by October 15 of the following year, regardless of whether you requested an extension to file your tax return.
  • If you recharacterize all or part of a rollover or conversion to a Roth IRA, you cannot reconvert the amount recharacterized to the same or another Roth IRA until the later of (1) 30 days after the recharacterization, or (2) the year following the year of the rollover or conversion.

Although not discussed in the IRA guide cited above, you can also recharacterize contributions. For example, you can recharacterize a Roth IRA contribution into a traditional IRA (Source: Investopedia). Note that recharacterizing contributions have the same time and other restrictions as recharacterizing a Roth conversion.

Now to the big question. Why would you want to recharacterize an IRA conversion or contribution? Here are 4 scenarios where this strategy can be helpful.

Why Recharacterize a Roth IRA Conversion

1. Market declines: Imagine you convert $100,000 to a Roth IRA, pay the taxes (we’ll assume 25% or $25,000), and then the value of your investments drops to $75,000. You’ve just paid $25,000 in taxes on an investment now worth $75,000.

If still within the deadline, one can recharacterize the conversion back to a traditional IRA. Then, after the appropriate waiting period, one can reconvert back to a Roth IRA. This time the conversion amount is $75,000, producing taxes of $18,750.

2. Reduce income to next highest bracket: A second scenario involves a partial recharacterization. In our above example, let’s assume the value of the investment stayed the same or even went up. Yet the $100,000 conversion placed you in a higher tax bracket than you had anticipated. A partial recharacterization may enable one to undo just enough of the conversion to place the taxpayer in a lower tax bracket.

Why Recharacterize an IRA Contribution

3. You can’t deduct an IRA contribution: Assume you make a $5,500 contribution to a traditional IRA during the year, with the intention of deducting the contribution from your taxes. Then you change jobs or get a promotion, and your increased salary combined with your workplace retirement account (or your spouse’s workplace retirement account) precludes you from taking the deduction.

Read: When can you deduct an IRA contribution

In this case you may wish you had contributed to a Roth IRA instead. One option would be to convert to a Roth. The downside is you’ll pay taxes on any of the earnings since your initial contribution. The alternative is to recharacterize the contribution to a Roth, where the money is treated as if you had contributed it to a Roth in the first place.

4. You prefer the deduction over a Roth: Finally, some may have contributed to a Roth, only to find that better than expected earnings moved them into a higher tax bracket. With the tax bill on the horizon, the deduction from a traditional IRA may now look more inviting. The recharacterization, assuming the conditions are met, could save the day.

And that brings us back to Chintan’s question. Why did the recharacterization amount differ from his initial investment? The difference was the result of investment earnings on the money while it was in the IRA.

Topics: InvestingPodcastRetirement Planning

2 Responses to “DR 102: 4 Times Recharacterizing an IRA Conversion or Contribution Can Save Your Bacon (Literally)”

  1. I contributed to a Roth IRA earlier this year. I also adjusted my tax with-holdings to lower my refund. I may have shorted myself on the with-holdings and end up owing the tax man more than expected. Could recharacterizing my Roth IRA contribution help lower my taxes? I am eligible for a partial deduction, based on my income.

    • Rob Berger
      Rob Berger

      Tyler, if your Roth IRA conversion was of pre-tax dollars that triggered taxable income, recharacterizing the conversion would reduce your taxable income. You would want to confer with a tax accountant to understand the exact impact on your taxes.

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