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Roth IRAs - Part 3: How to Recharacterize an IRA Contribution 1/25/2010
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This is the third in a series of Technical Updates, covering Roth IRA issues, including 2010 law changes, plan to Roth IRA rollovers, Roth IRA conversions, recharacterizations and reconversions, and taxation issues associated with Roth IRA transactions. This Part 3 discusses the definition of recharacterization and how to recharacterize an IRA contribution. Part 4 will discuss additional recharacterization rules.

Q-1: What is a recharacterization of an IRA contribution?

Recharacterization of an IRA contribution means treating a contribution made to one type (traditional or Roth) of IRA as made to a different type of IRA for the taxable year. An individual may recharacterize all or a portion of an IRA contribution. A taxpayer may recharacterize a contribution made either to a traditional IRA or to a Roth IRA. The recharacterized contribution may be any of the following:

  1. A regular contribution (i.e., a contribution not exceeding the taxpayer’s annual IRA contribution limit, either to a traditional IRA or to a Roth IRA),
  2. A conversion contribution (from a traditional IRA to a Roth IRA), or
  3. A rollover contribution (from an eligible retirement plan, such as a 401(k) plan, to a Roth IRA).

Q-2: What is the effect of a recharacterization?

The effect of a recharacterization is that the IRS treats a contribution made to the first IRA (IRA 1) and recharacterized as a contribution to the second IRA (IRA 2) as if the taxpayer originally had made the contribution to IRA 2 on the date of the contribution to IRA 1. The IRS will treat a recharacterized conversion or Roth IRA rollover from an eligible retirement plan as if the conversion or rollover had not occurred. For example, if a taxpayer recharacterized a traditional IRA contribution as a Roth IRA contribution, the taxpayer would not be entitled to a deduction for the contribution to the traditional IRA.

Q-3: How do I recharacterize an IRA contribution?

A recharacterization occurs when an individual: (1) transfers all or any portion of an IRA contribution (including a conversion contribution or a rollover contribution); (2) in a trustee-to-trustee transfer; (3) on or before the due date (including extensions) for the individual’s income tax return for the taxable year for which the individual made the contribution; (4) to another IRA. The taxpayer must transfer with the recharacterization amount the net income (or loss) attributable to the recharacterized amount.

Q-4: Can I recharacterize an IRA contribution even if the same IRA trustee holds both the original IRA (IRA 1) and the recharacterized IRA (IRA 2)?

Yes. The transfer may be between IRAs maintained by the same trustee. In such a case, the trustee can complete a transfer of the entire account merely by redesignating the transferor IRA as the transferee IRA.

Q-5: Why might I wish to recharacterize an IRA contribution?

A taxpayer might recharacterize an amount if: (1) the taxpayer erroneously thought he/she was eligible to make a regular Roth IRA contribution when in fact he/she was not; (2) the Roth IRA conversion amount (including a rollover contribution from a plan “converted" to a Roth IRA) sustained a loss, so that the value of the conversion contribution is less than the amount includible in income as a result of the conversion; or (3) the taxpayer simply decides, for any reason or no reason, that he/she would rather have a regular contribution amount (either traditional or Roth) made to the other type (either Roth or traditional) of IRA. In each case, the recharacterization election must be timely (see Part 4 of this series).

Example #1. Pam (a single person) expected her 2010 adjusted gross income would be $100,000, and she contributed $5,000 to a Roth IRA during 2010. However, because of a year-end bonus, Pam’s 2010 AGI is $125,000. Since her AGI exceeds $120,000, she cannot make a 2010 Roth IRA contribution. She may recharacterize her Roth IRA contribution as a traditional IRA contribution. (And she should recharacterize. Otherwise, Pam will have an excess contribution to the Roth IRA that is subject to an annual 6% excise tax until she eliminates the excess.)

Example #2. Sam, on March 1, 2010, converts $80,000 of his traditional IRA (all pre-tax dollars) to a Roth IRA. A year later, the value of the Roth IRA has decreased to $50,000. Rather than including the $80,000 conversion amount in income, Sam does not want to pay taxes on $80,000 that is now worth $50,000. He may recharacterize the contribution back to a traditional IRA contribution.

Example #3. Assume in the previous example Sam instead took the $80,000, on March 1, 2010, as an in-service distribution from his profit sharing plan and rolled the distribution to a Roth IRA. Sam still may recharacterize the Roth IRA rollover contribution as a traditional IRA contribution. (He does not recharacterize the contribution by rolling the Roth IRA contribution back to the distributing plan.)

Example #4. On July 1, 2010, Emily, age 55, makes a Roth IRA contribution of $6,000. On April 1, 2011, faced with a larger than expected 2010 tax bill, Emily reconsiders her IRA contribution decision, and decides she would like the IRA contribution to be a pre-tax contribution to a traditional IRA. She may recharacterize the contribution to a traditional IRA contribution.

In each of the preceding examples, the taxpayer must recharacterize on a timely basis. Part 4 of this series will discuss the timing rules.

We will discuss the Roth conversion process at the Advanced Pension Conference. In addition, Roth IRAs, conversion and related IRA issues will be the subject of ERISA Newsletter 2010-1. We also have added Roth IRA conversion and recharacterization forms to ERISA Forms. The ERISA Newsletter and ERISA Forms are part of The Pension Library.