Update: As of January 1, 2018, recharacterization of Roth IRAs is no longer possible due to the passage of the Tax Cuts and Jobs Act of 2017. Once you convert a traditional IRA to a Roth, you no longer have the option of changing back to a traditional. The below article describes how the process worked before this change.
Many people choose to convert their traditional IRAs into Roth IRAs. This means paying taxes now in exchange for enjoying tax-free growth and withdrawals down the road. If you regretted that decision, you could undo it through a process known as recharacterization. However, this is no longer allowed under current tax law.
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What Is Recharacterization?
Generally speaking, recharacterization was a process which allowed an investor to change how certain assets are treated and applied. It often involved taking tax efficiency into consideration.
Recharacterization was most commonly used for individual retirement accounts (IRAs). Say you were to convert your traditional IRA funds to a Roth IRA but then decided that the move wasn’t quite in your best interest. That’s where recharacterization came in, allowing you to undo that conversion.
Why Choose Recharacterization?
There are a number of reasons why you may have wanted to undo your IRA rollover or recharacterize an IRA contribution.
One reason to recharacterize was to change the tax treatment of your assets. When you converted to a Roth IRA, you might have done so expecting your taxes to be higher once you reached retirement. But perhaps your situation changed, and you’re realizing that your tax bracket will be lower come retirement. In this case, it might have made sense to recharacterize your Roth IRA back to a traditional.
Another reason for recharacterization was to claim a tax deduction for your traditional IRA contribution amount. In that case, you would have recharacterized a contribution from a Roth IRA contribution to a traditional IRA contribution. This would have allowed you to take a deduction for your contribution. That would come in handy if you needed a refund or were facing a steep tax bill.
How to Recharacterize
Recharacterization wasn’t as easy as moving your assets around yourself. You had to contact the financial institution that housed the IRAs involved in the recharacterization. You needed to provide information like the date of the original contribution and the amount you wanted recharacterized.
Your IRA custodian then moved your assets from one IRA to the other. Some institutions were able to simply change the IRA classification, without having to move your assets. It was important to contact your issuer as soon as you decided to make the reversal. This is because there was a deadline by which you had to make your recharacterizations. That deadline was generally six months after you filed your tax return in April. If you filed on tax day, you had to have recharacterized by October 15 of the year after you made the IRA contribution or rollover.
There was also a waiting period to reconvert money to a Roth IRA after a recharacterization. You had to wait either 30 days after the recharacterization or the year after the conversion or rollover, whichever came later.
Recharacterization of Gains and Losses
With any investment, you should expect gains and losses. With IRA recharacterizations, the IRS provided a formula to calculate your net income after these gains or losses.
First, subtract your adjusted opening balance from your adjusted closing balance. The adjusted opening balance is the fair market value of the IRA at the beginning plus any contributions or transfers. The adjusted closing balance is the fair market value of your IRA at the end plus any distributions, transfers or recharacterizations. Take that number and divide it by the adjusted opening balance. That amount multiplied by your contribution or conversion amount being recharacterized would have equaled your net gain or loss.
Now that recharacterization is no longer possible, some investors may be stuck paying too much in taxes if their investments lose value. For example, let’s say you convert $50,000 from your traditional IRA into a Roth IRA at the end of this year. You invest the $50,000 in an ETF that mirrors a large index, but by September of next year, that index is down 25%. You’ll have paid taxes on $50,000, but you’ll only have $37,500 to show for it.
There are a number of reasons why you might have wanted to recharacterize a Roth conversion or an IRA contribution. However, the Tax Cuts and Jobs Act banned the practice as of Jan. 1, 2018. Now that the option is off the table, it’s more important than ever to carefully think through a conversion from a traditional IRA to a Roth. Before you do so, consider speaking with a financial advisor to make sure that you’re making the best decision for your finances and your future.
If don’t already work with a financial advisor, SmartAsset’s free advisor matching tool can help you find one today. First you’ll answer a series of questions about your financial situation and goals. Then the program will match you with up to three advisors in your area who meet your needs. Finally, you can review their credentials and speak with them over the phone or in person to determine which one you’d like to work with.
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