Before you complete your tax return for the year, you don’t always know whether it would be more beneficial to make a tax-deductible traditional IRA contribution or an after-tax Roth IRA contribution. But, what if you could invest your money in a self-directed IRA now and then choose your tax benefit when you know which type of contribution would best suit your financial situation this year? Under a little know tax provision, called “recharacterizing,” you can!
Recharacterizations
A recharacterization is a means of treating an IRA contribution as if it were made to a different type of IRA. For example, if you make a traditional IRA contribution, you could recharacterize that contribution and treat it as though it were originally made to a Roth IRA. Alternatively, if you made a Roth IRA contribution, you could treat that contribution as if it were made to a traditional IRA. There are no tax consequences or IRS penalties for recharacterizing a contribution. And you have until your tax return deadline, plus extensions, to complete the recharacterization. You just have to make sure that you are eligible to contribute to that other type of IRA.
Wait and See Example
Jared and Ashley are married, in their 30s, and both work in sales. They do not participate in an employer's retirement plan, so they like to use their first commission checks of the year to fund their IRAs. This ensures they save for retirement and put their money to work as soon as possible each year. For 2018, they each made a $5,500 contribution to a Roth IRA (total of $11,000) because they value the benefits of tax-free investment growth and tax-free income in retirement.
Because their income level varies each year, however, their tax liability can be hard to predict from year to year. If 2018 turns out to be a stellar sales year, they may determine that an $11,000 tax deduction for traditional IRA contributions would lower their tax liability for the year. If they choose to recharacterize their 2018 Roth IRA contributions into 2018 traditional IRA contributions and claim the tax deduction on their 2018 return, they would need to complete the recharacterization by October 15, 2019.
How It Works
To recharacterize a contribution, you must instruct your IRA custodian, in writing, to move the current-year contribution from one IRA to another IRA, and include the following information:
- The type and amount of the original contribution
- The date on which the original contribution was made
- Directions to recharacterize the contribution plus the investment earnings or loss attributable to the contribution
- The names of the sending and receiving IRA custodians
- Any other additional information and instructions needed to accomplish the transaction
Even though this is a tax-free transaction, you and your IRA custodian(s) will have to report the recharacterization to the IRS. Your IRA custodian(s) will report the original contribution to the first IRA with an IRS Form 5498, the withdrawal from the original IRA with an IRS Form 1099-R, and the deposit into the other type of IRA with another IRS Form 5498. You will need to explain these transactions to the IRS on your tax return.
Correcting Excess Contributions
A recharacterization can also be used to correct an excess IRA contribution that occurs because you are ineligible to make the contribution. For example, if you are age 72 and contributed to a traditional IRA this year, you would have an excess contribution because you are not eligible to contribute to a traditional IRA. However, as long as you are still earning income that meets the Roth IRA eligibility requirements, you would have the option to recharacterize your excess traditional IRA contribution to a Roth IRA.
Remember
Only current-year contributions may be recharacterized. This means that if a contribution was made for a tax year for which the tax-filing deadline extension has passed, the contribution can no longer be recharacterized.
To learn more about recharacterizations