“A leopard can’t change its spots,” as the old saying goes, but the tax nature of an IRA contribution can be changed to give you the type of tax benefit you want. A “re-characterization” is an IRA transaction that can be used to move an IRA contribution made to one type of IRA to another type of IRA. For example, if you make a Traditional IRA contribution, you could choose to re-characterize that contribution as a Roth IRA contribution instead. Alternatively, if you made a contribution to a Roth IRA, you could treat that contribution as if it were made to a Traditional IRA.
IRA owners may want to re-characterize a contribution because they were not eligible to make that type of contribution or because they changed their minds about the type of contribution they want to make. The only catch is the re-characterization must be done by a certain deadline, or it can’t be done.
What is the deadline to re-characterize?
Re-characterizations are only available during a short window of time because they change the tax nature of a prior-year contribution in time to reflect it on the prior year’s tax return. The re-characterization must be completed by your tax-filing deadline, including extensions, for the year for which the contribution was made. This includes an automatic six-month extension if you file your tax return on time. If you file on a calendar-year basis, the deadline to re-characterize an annual contribution is October 15 of the following year.
Who is eligible?
To be able to re-characterize an IRA contribution, you must be eligible to contribute to the receiving IRA. Let’s assume an individual was over age 70½ and contributed to a Traditional IRA. This is an excess contribution because annual Traditional IRA contributions cannot be made after the IRA owner reaches age 70½. This individual may re-characterize the contribution to a Roth IRA as long as they meet the Roth eligibility requirements. That is, they had earned income that falls within the limits for contributing to a Roth IRA.
What are the steps to make a re-characterization?
To initiate a re-characterization, you must request a re-characterization from the IRA custodian holding the assets that will be re-characterized. If the re-characterized amount will be transferred to another IRA custodian, you may also want to notify the receiving custodian that a re-characterization will be coming. Any investment gain or loss relating to the amount being re-characterized must also be moved to the other type of IRA. Your IRA custodian will help with this calculation. When you provide instructions to transfer the contribution (plus earnings) from the first IRA to the second IRA, and any additional information that may be needed, the custodian of the original contribution will directly transfer the money or investment to the other IRA.
Even though a re-characterization is not taxable, all the money movements must be reported to the IRS. The IRA custodian will report the original contribution on Form 5498, just as it occurred, and the subsequent withdrawal of the original contribution from the first IRA will be reported on Form 1099-R. The IRA custodian of the receiving IRA must report the re-characterized amount received on another IRS Form 5498. The IRS uses the information on Forms 1099-R and 5498 each year to confirm the information reported by taxpayers on their federal income tax returns for deductible IRA contributions, taxable distributions, and nontaxable re-characterizations.
Henry, is age 52 and single. He contributes $6,500 to his Roth IRA on May 15, 2018, as a 2018 contribution. While preparing his 2018 taxes in March 2019, Henry discovers that he is not eligible to make a Roth IRA contribution because his 2018 income exceeds the limits for Roth IRA eligibility.
Henry instructs his IRA custodian to re-characterize the $6,500 Roth IRA contribution to his Traditional IRA at the same institution. Henry’s IRA custodian helps Henry calculate the earnings attributable to the $6,500 contribution ($650), and transfers $7,150 from Henry’s Roth IRA to his Traditional IRA. Henry may take a tax deduction for a 2018 Traditional IRA contribution since he is eligible for the tax deduction (he is under age 70½, has earned income, and does not participate in an employer’s retirement plan).
If you want to re-characterize a contribution you made for 2018, you can do so up until October 15, 2019, if you timely file your 2018 tax return. If you filed your 2018 tax return before realizing you want to re-characterize a 2018 contribution, you may still make a timely re-characterization but will need to file an amended tax return.
Please consult with your tax and/or financial advisor if you want to make a re-characterization to be sure you understand the tax consequences.
You may initiate a re-characterization request with STRATA Trust through our IRA Recharacterization Request and Certification form.
If you have questions, please contact STRATA Trust at 866-928-9394 or Service@StrataTrust.com.