- Anyone can do a re-characterization for any reason
- A partial re-characterization can be done
- The re-characterized funds go back to a traditional IRA and are treated as if they never left the IRA
- A 2012 conversion must be re-characterized by October 15, 2013
- 2013 conversion must be re-characterized by October 15, 2014
- Both the Roth and the traditional IRA custodians must be notified of the re-characterization in writing
- The re-characterization must be done as a trustee-to-trustee transfer (a direct transfer, NOT a withdrawal from the Roth IRA and a subsequent deposit to an IRA)
- The re-characterized funds can go back to the same or a different IRA custodian
- The re-characterized amount is a net amount (gains or losses on the account are attributed to the re-characterization amount)
Undoing Your Roth Conversion
October 15th Deadline
Account owners have until October 15th of the year following the year of a conversion to re-characterize that Roth conversion. IRS has the authority to extend the time to re-characterize and has done that for many taxpayers who have requested Private Letter Rulings. But that is an expensive and time-consuming route and the extension is generally granted only in cases where the taxpayers did not qualify for the conversion in the first place. The extension of time to re-characterize has never been granted because the value of the investments in the converted Roth declined.
A re-characterization means reversing a Roth IRA conversion as if it never happened. The deadline is October 15, 2013 to re-characterize a 2012 conversion even if the 2012 tax return has already been filed. If the return was already filed, then an amended return will have to be filed on Form 1040X (and an amended state tax return, if applicable) to receive a refund of any tax paid on the conversion. Taxpayers have three years from the original due date (or extended due date) of the return to file an amended tax return, but would probably want to file it quickly to receive their tax refund faster. The re-characterization though still must be completed no later than October 15th.
Other IRA and Roth IRA Recharacterizations
Roth conversions are not the only transactions that can be recharacterized. You can also recharacterize Roth IRA and traditional IRA contributions (the $5,500 per year contributions).
Clients may have contributed to a traditional IRA and now realize that they cannot deduct that contribution because they are active in a company plan and their income is too high. They can re-characterize the traditional IRA contribution to a Roth IRA (if they otherwise qualify for a Roth IRA contribution). Or maybe they contributed to a Roth IRA, but they now see that they would qualify for a tax deduction if they had contributed to a traditional IRA instead. They can recharacterize to a traditional IRA. A third possibility is that a client contributed to a Roth IRA and their income is too high. The simplest way to solve this problem is to re-characterize the contribution to a traditional IRA. The re-characterized contribution is treated as if it were originally made to that IRA.
For example, if Douglas contributed to a Roth IRA for 2012 in March of 2013 and then recharacterized the contribution to a traditional IRA before October 15, 2013, the contribution will be treated as if it was made on the same date it was originally made to his Roth IRA. It is treated as a timely 2012 traditional IRA contribution even though the actual money did not get deposited in the traditional IRA until October 2013.
A contribution can only be re-characterized for the year the amount was originally contributed. For instance, if a Roth IRA contribution was made for 2012, you cannot re-characterize the contribution as a 2013 traditional IRA contribution. Instead, the amount can only be re-characterized as a 2012 traditional IRA contribution. It could also be withdrawn as an excess contribution (along with any earnings) for 2012 and then a 2013 IRA contribution could made, but then you would have no IRA contribution for 2012.
Reasons to Recharacterize a Conversion
Why would anyone want to recharacterize if they don’t have to?
The main reason people voluntarily re-characterize is because the account has declined in value. A re-characterization cancels out the conversion and the conversion tax is eliminated.
Another reason people re-characterize is because they have a change of heart. You are permitted to re-characterize for any reason, for that matter. When tax time rolls around, some people get a case of buyer’s remorse and don’t want to pay the tax on the conversion. That’s perfectly ok.
– No one has to recharacterize anymore due to income or filing status since these restrictions were permanently repealed for 2010 and later year conversions.
The distribution from a traditional IRA to a Roth IRA must take place by the end of the year to qualify as a conversion for that year. But there is no risk because the account owner can always recharacterize. The recharacterization is one of the rare second chances granted by the tax code and allows great flexibility in a client’s financial and tax planning.
Don’t let death stop you from recharacterizing!
The Roth IRA Regulations allow a post-death recharacterization by the executor. For example, if an IRA owner converted in 2012 and died in July 2013, the executor or other estate representative still has until October 15, 2013 to recharacterize the conversion. This can be done even if the decedent’s 2012 tax return was already filed.
Roth IRA Regulations Section 1.408A-5, A-6(c):
(c) The election to recharacterize a contribution described in this A-6
may be made on behalf of a deceased IRA owner by his or her executor, administrator, or other person responsible for filing the final Federal income tax return of the decedent under section 6012(b)(1).
How Do I Recharacterize?
Since a recharacterization reverses a Roth conversion, you would have to transfer the converted funds back to a traditional IRA and that transfer must be a trustee-to-trustee transfer. This means that the funds must go directly from the Roth IRA to the traditional IRA. If the recharacterization is between two different trustees, the assets must be made payable to the new trustee, for benefit of the IRA owner. You cannot withdraw the converted funds from the Roth IRA and then deposit them back into a traditional IRA. That is a rollover and not a direct trustee-to-trustee (institution to institution) transfer and will not qualify as a recharacterization. The funds transfer must be completed by October 15th of the year following the year of the conversion.
Clients can do either a full or partial recharacterization. With a full recharacterization of a Roth IRA that holds only the converted funds, the mechanics are easy. You simply transfer the entire balance in the converted Roth account to a traditional IRA and it’s done. Check with the IRA custodian or trustee about their documentation requirement. For a partial recharacterization, a net income calculation is done on the entire account and the resulting gains or losses are apportioned to the recharacterization amount. The net amount is then transferred back to the traditional IRA.
What if a client wants to convert again? New IRA funds can be converted at any time but if a client wishes to re-convert the same funds that they have just re-characterized, they must wait more than 30 days. The rule says that once you convert and then re-characterize, you cannot reconvert those same funds until the year after the year of the conversion or more than 30 days after the re-characterization, whichever is later.
If the original conversion was in 2012 and was recharacterized on October 14, 2013, then you must wait until November 14, 2013 (31 days) to reconvert those same funds back to a Roth IRA. At first it may appear that you should have to wait until 2014 to reconvert, but that is not the case because this was a 2012 conversion and 2013 is already the year after the conversion, so the 30 days is the longer time period.
Your clients may benefit by reconverting. In fact, from a tax standpoint, they may be better off. Once the re-characterization is done, the funds can be reconverted from the traditional IRA to a Roth IRA. The tax due on the reconversion is calculated on the new, lower, conversion amount. The Roth will have the same value that was in the account before the re-characterization, but for a substantially smaller tax bill (assuming the value of the stock remained level for the period of time between the re-characterization and the re-conversion).
What about a volatile stock market?
In a shaky market, explain the possible benefits of reconverting, to give clients more time to evaluate their conversion decisions.
Clients have until October 15, 2014, to decide whether to keep a 2013 Roth conversion.
Disclosure: The information provided is for educational and informational purposes only. This should not be construed as tax or legal advice. Should you require tax or legal advice, please contact a tax or legal professional licensed to offer advice in your area.