8.22 Recharacterizations and Reconversions
When you convert a traditional IRA to a Roth IRA (8.21), you have an opportunity to reconsider the move. You can in effect “undo” the conversion by recharacterizing all or part of it. If you timely file your return for the year of the conversion, you have until October 15 of the following year to complete a recharacterization; see below for deadline details.
You may want to recharacterize because the value of the Roth IRA has dropped substantially since the conversion, and you do not want to pay the tax that would be due on the higher value at conversion, or you may simply be unable to pay the tax due on the conversion (8.21). In a declining stock market, a recharacterization may be the first step in a plan to reconvert back to a Roth IRA when the taxable conversion value is lower, subject to the waiting period for reconversions (see below).
You make an election to recharacterize the conversion by making a trustee-to-trustee transfer of the Roth IRA contribution (part or all) to a traditional IRA; it does not have to be the same traditional IRA from which the conversion was made. You can also recharacterize by keeping the account with the same trustee and notifying the trustee to transfer the account to a traditional IRA. The transfer must include any net income allocable to the contribution being recharacterized. If there has been a loss in value since the conversion, the allocable negative net income reduces the amount that must be recharacterized to a traditional IRA. The Roth IRA trustee generally figures the net income or loss allocable to the recharacterized contribution; IRS Publication 590 has a worksheet for calculating the amount.
You must notify both trustees (if different) of your intent to recharacterize by specifically identifying the original contribution that is being recharacterized and the amount being recharacterized and you must direct the transferor trustee to make the transfer, including any allocable income.
The effect of the recharacterization is to disregard the conversion to the Roth IRA and to treat the contribution as if it had been contributed to the transferee traditional IRA (to which recharacterization was made) on the date of the conversion. The recharacterized contribution is not treated as a rollover for purposes of the one-rollover-per-year rule (8.10).
Other types of recharacterizations.
You may recharacterize an annual Roth IRA contribution (8.20) as a traditional IRA contribution, where this might enable you to obtain a deduction for the traditional IRA contribution (8.4). If you initially contribute to a traditional IRA, you may be able to recharacterize the contribution as an annual Roth IRA contribution. See the Planning Reminder in this section.
Deadline for recharacterizing a conversion.
IRS regulations generally require that a recharacterization election and the actual transfer be made on or before the due date, including extensions, for filing the tax return for the year of the conversion. However, the IRS allows timely filers an automatic extension of six months from the original filing due date, excluding extensions. To recharacterize a conversion made in 2012, you have until October 15, 2013, provided that you timely file your 2012 return, including any extension. See the instructions to Form 8606 for how to report the conversion and the recharacterization. If you file a timely 2012 return and pay tax on the converted amount, and then recharacterize by the October 15 deadline, you must file an amended return. For example, by April 15, 2013, you file your 2012 return, which includes a taxable conversion made in 2012, and then by October 15, 2013, you recharacterize the converted amount back to a traditional IRA. You must file an amended 2012 return to report the recharacterization and claim a refund for the tax paid on the conversion. The amended return must be filed within the regular amendment period, generally three years (47.1). On the amended return, write “Filed pursuant to Section 301.9100-2.”
What if you miss the IRS recharacterization deadlines? A regulation gives the IRS authority to grant an extension if an “innocent” mistake was made and you act in good faith by promptly asking the IRS for the additional time after discovering the error (Reg. Sec. 301.9100-3). In several private rulings, the IRS has allowed the extra extension to taxpayers who missed the deadline and who requested recharacterization relief before the IRS discovered that they did not qualify for the conversion under the pre-2010 $100,000 MAGI limit (8.21), or that the attempted recharacterization had not been timely made. At the time of each request, the statute of limitations had not yet passed; if it had, the IRS would almost surely have denied the requests. In one private ruling, the IRS allowed extra time to recharacterize a Roth IRA back to a traditional IRA after an IRS audit uncovered additional income that pushed a taxpayer over the $100,000 MAGI limit. The taxpayer, according to the IRS, had acted reasonably and was not aware of the excess income. Given the repeal of the income restriction for years after 2009, it is less likely that the IRS will grant extensions beyond the extended October 15 deadline.
Planning Reminder
Reconverting to a Roth IRA after a recharacterization.
As discussed above, a traditional IRA that has been converted to a Roth IRA may be transferred back to a traditional IRA in a recharacterization. That amount may subsequently be reconverted back to a Roth IRA. This recharacterization/reconversion rule may allow an IRA owner to lower the tax due on a conversion to a Roth IRA. For example, if you convert a traditional IRA to a Roth IRA and the value of the account drops as a result of a stock market decline, you may be able to reduce the taxable conversion amount value by recharacterizing the account as a traditional IRA and then reconverting to a Roth IRA at a time when the value of the account is lower. The amount that you must include in income from the conversion is based on the value of the account as of the date of the reconversion.
However, the IRS has imposed a waiting period before a reconversion may be made. You may not convert to a Roth IRA, recharacterize back to a traditional IRA, and reconvert the same funds to a Roth IRA in the same calendar year. If you converted a traditional IRA to a Roth IRA and also recharacterized that amount back to a traditional IRA during 2012, you may not reconvert those same funds to a Roth IRA until January 1, 2013. If the recharacterization was made in the last 30 days of 2012, you must wait until the 30th day following the date of the recharacterization before a valid reconversion may be made in early 2013.
The 30-day waiting period also applies if in 2013 you recharacterize a conversion made in 2012; see the Joe Smith Example below. A reconversion after the 2013 recharacterization is treated as a new conversion in 2013.
Caution
The effect of the waiting period is to make it impossible to take immediate advantage of a stock market decline that lowers the value of a Roth IRA. If you want to recharacterize back to a traditional IRA and then reconvert to a Roth IRA in order to lower the taxable conversion amount, you will have to wait a minimum of 30 days following the conversion before you can reconvert and if you converted and recharacterized an amount in the same year, you cannot reconvert until the following year. By that time, the value of the reconverted account may be as high, or higher, than it was at the time of the recharacterization.
If a reconversion is attempted before the end of the waiting period, the attempt will be treated as a “failed” conversion. A failed conversion is treated as a taxable distribution from the traditional IRA followed by a regular contribution to a Roth IRA. The pre–age 59½ early distribution penalty could apply to the taxable distribution (8.12) and the excess of the deemed regular contribution to the Roth IRA over the annual limit would be subject to the 6% excess contribution penalty (8.7). A failed conversion may be remedied by making a timely recharacterization to a traditional IRA.