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Can I Get An IRA “Do Over”?

Many IRA owners carefully weigh the benefits and considerations of saving for retirement in a Traditional IRA vs. a Roth IRA, and then pick the one that meets their tax and savings objectives.

Traditional IRA:
Contributing to a Traditional IRA may allow you to take a tax deduction for your contributions. A tax deduction will potentially lower the amount of income tax you owe for the year. Although you’ll pay tax on your IRA contributions and investment earnings when you withdraw from the IRA, presumably you’ll be retired and paying tax at a lower rate than you are today.

Roth IRA: Contributing to a Roth IRA will not reduce your taxable income for the contribution year. But by paying tax on that income now, you won’t owe any tax when you withdraw the contributions from your Roth IRA, no matter when you take the money out or what your tax rate is at that time. If you take a “qualified” distribution, the investment earnings in your Roth IRA will also be tax-free – which can add up to a significant value the longer your contributions have to grow.

But what if, after contributing to one type of IRA for the year, you change your mind or your tax circumstances change, and you wish you would have contributed to the other type of IRA? If you’re eligible, you can recharacterize your IRA contribution to the other type of IRA.

Eligibility

The IRS allows you to recharacterize your IRA contribution to the other type of IRA if

  1. You are eligible to contribute to the other type of IRA, and
  2. You complete the recharacterization by the deadline.
    You may recharacterize part or all of your contribution. Any investment gain or loss attributed to the amount being recharacterized must also be moved to the other type of IRA.

Deadline

The deadline to recharacterize a contribution is your tax-filing deadline plus extensions for the year for which the contribution was made. If you timely file your tax return, including extensions, you have an automatic six-month extension to recharacterize an IRA contribution. For example, if an IRA owner made an IRA contribution for 2021, and they file a 2021 tax return on time (including extensions), they have until October 15, 2022, to complete the recharacterization.

Amended Tax Return

Recharacterizations must be reflected on your tax return. If a tax return for the year was filed before a recharacterization was completed, the taxpayer must file an amended return to explain the recharacterization and claim or not claim a deduction for the IRA contribution, as applicable.

Examples

Here are a few scenerios in which a “do over” would provide a tax advantage:

Increased Income

Jane is employed by a big corporation and contributes the maximum amount to her employer’s 401(k) plan and her Traditional IRA each year. After having her 2020 taxes done, she learned that the raise she received last year for successfully managing her team remotely brought her income to a level that exceeds the limit for being eligible to deduct a Traditional IRA contribution.

If her contribution has to be after-tax, she would rather contribute to a Roth IRA than make a non-deductible Traditional IRA contribution. To recharacterize her 2020 Traditional IRA contribution, she must open a Roth IRA and request her IRA custodian to recharacterize her Traditional IRA contribution, along with investment earnings, to a Roth IRA by October 15, 2021.

No 401(k) Option

Joe is young, with a long time horizon until retirement. He defers some of his income into his employer’s 401(k) plan and contributes to a Roth IRA each year to shield those investment earnings from taxation assuming his distributions will be “qualified.” This year, he started his dream job with a start-up tech company. The new company doesn’t yet offer a 401(k) plan.

Since Joe can no longer reduce his taxable income by deferring salary into a 401(k) plan, he would rather take a deduction for a Traditional IRA contribution to help lower his tax liability this year rather than put more money into his Roth IRA. To recharacterize his 2021 Roth IRA contribution, he will need to open a Traditional IRA and request a recharacterization of the Roth IRA contribution, along with the investment earnings, to his Traditional IRA by October 15, 2022.

Excess Contribution

Matt and his spouse are real estate agents. Matt contributes to his self-directed Roth IRA every year so he can grow his IRA’s real estate investments tax-free. With the hot real estate market this year, he and his spouse’s income will exceed the limit for being eligible to contribute to a Roth IRA this year. Matt now has an excess contribution in his Roth IRA, which he can correct by recharacterizing the contribution to a Traditional IRA before October 15, 2022.

Next Steps

Please consult with your tax and/or financial advisor to be sure you understand all the consequences of a recharacterization. You may initiate a recharacterization request with STRATA Trust through our IRA Recharacterization Request and Certification form.

Tags: 401k, IRA, IRS Rules, Roth IRA, tax strategy