What Is a Reconversion?
An individual retirement account (IRA) reconversion—or recharacterization—allowed investors to reverse a Roth IRA conversion by shifting the funds back into a traditional IRA. However, the Tax Cuts and Jobs Act of 2017 banned the practice. Today, a Roth IRA conversion is irrevocable—once you transfer funds into a Roth, you can’t undo the move.
- When you convert funds from a traditional individual retirement account (IRA) into a Roth IRA (via a Roth IRA conversion), you pay ordinary income tax on the converted amount—and the tax bill could be substantial.
- An IRA reconversion (aka recharacterization) allowed investors to undo a Roth IRA conversion and move the funds back into a traditional IRA.
- The Tax Cuts and Jobs Act of 2017 banned the practice of recharacterizing a Roth IRA conversion.
- As of Jan. 1, 2018, all Roth IRAs conversions are irrevocable.
Understanding Reconversion and Recharacterization
In the past, a person could recharacterize a Roth IRA conversion back into a traditional IRA. However, one of the provisions in the Tax Cuts and Jobs Act banned the practice.
Reconversion was popular since it offered individuals a way to undo a Roth IRA conversion that didn’t go as planned. Here’s an example: Say you convert $50,000 from a traditional IRA into a Roth IRA. The entire $50,000 is taxable in the year of the conversion since you’re moving money from a pretax traditional IRA into an after-tax Roth. Remember, you pay taxes on distributions from traditional IRAs. But qualified Roth IRA withdrawals are tax free—so you need to settle those taxes when the money goes into the account.
Now, assume the stock market tanked after you did the conversion and the IRA has declined in value to $25,000 before the tax-filing deadline. At the end of that tax year, you would still owe taxes on the total converted amount—$50,000 in our example. In other words, you would owe tax on $50,000 for converting to a Roth, but you would only have $25,000 in the account at the end of the year. The Roth IRA conversion would seem like a big mistake in a situation like this.
In the past, investors could recharacterize the newly created Roth IRA back into a traditional IRA, thereby getting out of a tricky situation. However, reconversion is no longer an option; once you do a Roth IRA conversion, there’s no turning back.
IRA Contribution Recharacterization
While you can no longer undo a Roth IRA conversion, you can recharacterize a Roth IRA contribution into a traditional IRA contribution and vice versa. For instance, if you contributed $4,000 to a Roth IRA, you could recharacterize it as a $4,000 traditional IRA contribution.
You can’t recharacterize employer contributions under a Simplified Employee Pension (SEP) IRA or Savings Incentive Match Plan for Employees (SIMPLE) IRA plan as contributions to another IRA.
Recharacterizing a contribution allows you to change your mind or correct a mistake. For example, you might want to recharacterize if you contributed to a Roth and later realized your income was too high to do so. Similarly, you might recharacterize a contribution if you find out that you can’t deduct your traditional IRA contribution—or you don’t need any more tax deductions that year.
The year when you made the first contribution is the tax year to which that contribution relates—not necessarily the year when you actually contributed. Remember that you generally have until tax day (usually April 15) to make a prior-year contribution.
You have until the due date for filing your federal income tax return (including any extensions) to recharacterize a contribution. And, provided you recharacterize your contribution by this deadline, you can treat the contribution as though you made it directly to the second IRA. This means that you can effectively ignore your contribution to the first IRA.
How do you recharacterize an individual retirement account (IRA) contribution?
To recharacterize an individual retirement account (IRA) contribution, ask your IRA custodian to transfer the amount—including the contribution and related earnings—to a different type of IRA. The recharacterization can occur within the same institution (if you use one custodian for both IRAs) or via a trustee-to-trustee transfer if different providers maintain your IRAs. You can generally do all of the paperwork online or using your provider’s standard forms.
How much can I contribute to my IRA?
For the 2021 and 2022 tax years, you can contribute up to $6,000 to your Roth and traditional IRAs. If you’re age 50 or older, you can make an additional $1,000 catch-up contribution. The limit is the combined total for all of your IRAs—it’s not a per-IRA limit.
How do you allocate earnings when recharacterizing IRA contributions?
If you recharacterize an IRA contribution, you have to transfer the contribution and any earnings (or losses) related to those funds. The easiest way to determine the correct amount is to ask your IRA provider. They will be able to tell you the earnings (or losses) that are attributable to the contribution that you want to recharacterize.
However, suppose the contribution that you want to recharacterize represents the entire IRA balance (e.g., you’ve made just one contribution to that IRA). In that case, you can transfer the whole amount without worrying about the earnings or losses.