Recharacterization

DEFINITION of 'Recharacterization'

Recharacterization is the reversal of an IRA conversion, such as from a Roth IRA back to a traditional IRA, generally to achieve better tax treatment. Recharacterizations are mostly performed after a conversion from a traditional Individual Retirement Account (IRA) to a Roth IRA. Such a conversion, also known as a "rollover," may result in a significant and unexpected tax burden — so much so that the individual who has done the conversion decides to undo it, which results in a recharacterization. With recharacterizations, there are a number of important Internal Revenue Service (IRS) procedures and deadlines to be aware of.

BREAKING DOWN 'Recharacterization'

When talking about IRAs, recharacterizations and conversions are essentially opposite actions. A conversion refers to taking assets in a traditional IRA — or a similar type of retirement account involving pre-tax dollars — and moving them into a Roth IRA. A recharacterization reverses a conversion (or rollover). In either action, tax considerations play a part.

The deadline for recharacterizing a traditional IRA (or other retirement plan) to a Roth IRA conversion is the extended tax deadline of Oct. 15. Meeting that deadline means you can treat any contribution as a traditional IRA contribution (not taxed). For example, if you converted in 2018 you would have until Oct. 15, 2019 to complete a recharacterization. You can also amend and submit a new tax return if you have already filed taxes for the conversion year. Upon recharacterization, you will need to wait until either 30 days or until the next calendar year (whichever is longer) to reconvert to a Roth IRA.

IRS Form 8606 must be filled out to perform a recharacterization. The IRS provides several resources on IRA recharacterizations, such as a Form 8606 informational page, frequently asked questions on recharacterizations, and instructions for Form 8606.

Recharacterization and Conversions

Retirement accounts that are eligible to convert to a Roth IRA include the following:

  • Traditional IRA
  • Rollover IRA
  • 401(k) plan from a former employer
  • 403(b) plan from a former employer
  • 457(b) plan from a former employer
  • SIMPLE IRA
  • SEP IRA
  • SARSEP IRA

A conversion from one of the above pre-tax accounts creates a taxable event, which equates to any assets converted must be included into taxable gross income. This introduces several tax planning decisions, such as whether it makes sense to make the conversion over many years or wait until a year that you are likely to be in a lower tax bracket. The upside of a conversion to a Roth IRA comes with added flexibility in taking distributions. Since Roth IRAs are funded with dollars that are already taxed, there are no required minimum distributions that can complicate tax planning later in life. A Roth IRA conversion also ensures that a retiree will not have to worry about potential federal tax hikes later in life.