Taxpayers who recharacterize Roth conversions and IRA contributions are faced with the daunting task of calculating the earnings (or losses) on the amount, if such services are not provided by their IRA custodians. Proper calculation of the earnings/loss is as important as the recharacterization itself, and failure to include the correct amount could cause adverse consequences. Here we explain recharacterizations and help you understand the mechanics of calculating earnings or losses on the amounts you want to recharacterize.
Deadline to Recharacterize
The deadline for recharacterizing a Roth conversion or IRA contribution is your tax-filing deadline plus extensions. If you file the tax return on time (generally by April 15), you receive an automatic six-month extension, which means your deadline to recharacterize a 2015 contribution is October 15, 2016.
An individual may choose to recharacterize a Roth conversion for a few reasons: the conversion is a failed or ineligible conversion, the value of the assets has declined in value since conversion,* or the individual simply changed his or her mind and no longer wants to keep the assets in a Roth IRA. (For more insight, see Did Your Roth IRA Conversion Pass or Fail?)
*When assets are converted, the taxable amount of the conversion is the value at the time the amount is initially converted, even if the assets have declined in value. For instance, if an individual converted assets valued at $100,000, and the assets declined in value to $50,000, the individual must pay tax on $100,000. As a result, many individuals choose to recharacterize conversions that have declined in value, thus removing any tax liability associated with the conversion.
An individual may choose to recharacterize an IRA contribution to change the initial designation. For instance, an individual who makes a Traditional IRA contribution may recharacterize the contribution to a Roth IRA, thereby changing the contribution to a Roth IRA contribution, or vice versa.
The individual may choose to recharacterize a traditional IRA contribution if he or she is ineligible to receive a deduction for the contribution and feels it is then better to treat it as a Roth IRA contribution, for which earnings accrue on a tax-free basis. Alternatively, an individual may recharacterize a Roth IRA contribution to a Traditional IRA contribution in order to claim a tax deduction for the amount, or because he or she is ineligible for the Roth IRA contribution. Of course, the individual may recharacterize the amount simply because he or she feels the other IRA is a better financial choice. (See Roth or Traditional IRA … Which is the Better Choice? for reasons why an individual may choose one type of IRA over the other.)
How to Recharacterize
To recharacterize a conversion or contribution, you must move the assets from the IRA that first received the contribution (or conversion) to the IRA in which you want the assets to be maintained. Some financial institutions will process the recharacterization by simply changing the IRA from one type to another. Check with your IRA custodian/trustee about its procedure and any documentation requirements for processing a recharacterization.
Calculating the Earnings/Loss for a Recharacterization
The IRS provides a special formula for calculating the earnings or losses on the amount that is being recharacterized.
Here is the formula :
Here is what each of the variables denote:
Net Income = The earnings or loss on the amount being recharacterized.
Contribution = The conversion or contribution amount being recharacterized.
Adjusted Opening Balance = The fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers (including the contribution that is being recharacterized and any other recharacterizations) made to the IRA during the computation period.
Adjusted Closing Balance = The fair market value of the IRA at the end of the computation period plus the amount of any distributions, transfers or recharacterizations made from the IRA during the computation period.
The computation period begins immediately prior to when the contribution being recharacterized is made to the IRA and ends immediately prior to the recharacterizing of the contribution. If the IRA is not valued on a daily basis, then the most recent available fair market value preceding the contribution may be used as the beginning of the period, and the most recent available fair market preceding the recharacterization is the ending fair market value.
Say, for example, that an IRA is not valued on a daily basis, and the owner receives monthly account statements. If the owner were recharacterizing a contribution in March 2013 and the contribution occurred in December 2012, he or she would use the November 2012 month-end value (from the November statement) as the beginning period (market value) and the February 2013 month-end statement as the ending fair market value.
The following examples illustrate how to calculate earnings/loss on an amount that is being recharacterized:
Jill has an existing Roth IRA with a balance of $80,000. In November 2014, Jill converted her traditional IRA, valued at $160,000, to her existing Roth IRA. In February 2015, Jill decides to recharacterize back to her traditional IRA the conversion that occurred in November 2014. In February 2015, her Roth IRA is valued at $225,000. Except for the conversion of $160,000, no other contributions or transfers were credited to the Roth IRA. No distributions occurred from the Roth IRA. Jill must add any earnings that accrued on the $160,000 (or subtract any loss) and recharacterize the total. She calculates the earnings as follows:
Jill's net loss on the conversion of $160,000 is $10,000. Therefore, she must recharacterize no more or less than $150,000 ($160,000-$10,000).
To treat the $400 as a Roth IRA contribution, Jack must recharacterize the amount to his Roth IRA and must include any earnings or subtract any loss on the $400. The value of Jack's Traditional IRA when he recharacterizes the $400 in April is $7,600. No other contributions were made to the IRA and no distributions were made from it. Jack calculates the earnings/loss as follows:
The contribution of $400 earned $75 during the computation period. Jack must therefore recharacterize $475 ($400 + $75) to his Roth IRA. For tax purposes, the $400 will be treated as though it were made to the Roth IRA from the beginning.
Calculation Not Required for Full Recharacterization
A calculation of earnings or loss is required only if a partial recharacterization is being done. In other words, if the full IRA balance is being recharacterized, then no calculation is required. For instance, assume you established a new Roth IRA and funded it with $3,000 in December 2014. By October 2015, the IRA earned $500, making the balance $3,500. In order to claim a deduction for the $3,000, you decide that you want to treat the amount as a Traditional IRA contribution. Because the Roth IRA received no other contributions or made no distributions and because the IRA had no balance before the $3,000 contribution, you can simply recharacterize the full balance to the traditional IRA. The same rule applies if a full recharacterization of a Roth conversion is being done and no other distributions or transfers were made from or to the account.
A recharacterization can be done "in-kind," which means it can be done with securities that are in the account, not just cash. The key is to ensure that the securities being recharacterized equal the value of the recharacterization. For example, assume that in Example 2 above, Jack used his $1,600 contribution to purchase 100 shares of Widgets & Bidgets (W&B) stock. The rest of his IRA balance was made up of cash and mutual funds. Even though the $1,600 was invested in W&B stock, it is not necessary for Jack to recharacterize only shares of W&B stock. Instead, Jack may use any one or combination of W&B stock, mutual funds or cash, providing the value of the recharacterization does not exceed $475.
Your IRA custodian will report your IRA contributions (to you and the IRS) on IRS Form 5498. This contribution will be reported even if it is later recharacterized, which means that if you recharacterize your contribution, you will receive two Form 5498s, one for the initial contribution and a second for the amount that is credited to the other IRA as a recharacterization. You will also receive one Form 1099-R for the IRA that first received the contribution. Form 1099-R is used to report distributions from retirement accounts. Your custodian will use a special code in box 7 of the Form 1099-R to indicate that the transaction is a recharacterization and therefore not taxable. (Sometimes you get a 1099-R on a transaction you believed to be non-reportable. Find out what to do in Unexpected 1099-R Form: What To Do.)
Partial recharacterizations must be reported on IRS Form 8606. Form 8606 is filed with your tax return, but you need not file form 8606 for full recharacterizations.
The Bottom Line
Since a failure to calculate and report your recharacterizations could result in consequences, make sure you consult with a competent tax professional for assistance with making the choices that are right for you. Also, be sure to submit your recharacterization instructions to your Roth IRA custodian in advance of the deadline.