Here’s a closer look at what recharacterization is, how to recharacterize a contribution, and when you may need to use this strategy.
Definition and Examples of Recharacterization
Recharacterization is the process of “fixing” IRA contributions by moving them from one type of IRA to another type of IRA. For example, say you maxed out your Roth IRA this year. Come tax time, you find out you made too much money to qualify for a full contribution. You don’t want to get penalized by the IRS, so you do a recharacterization to move those excess funds to your traditional IRA.
How Does Recharacterization Work?
Recharacterization is the process of changing the IRS-qualified status of a contribution from one type of IRA to another. For example, you could recharacterize a Roth IRA contribution as a traditional IRA contribution or vice versa. Some common reasons why you may want to do a recharacterization include:
You exceeded the income limits for a Roth IRA and need to “undo” your contributions for the year. You contributed to a traditional IRA, thinking you exceeded the income limits for a Roth IRA but then learned that you do qualify to contribute to a Roth. Now you want to take advantage of the tax benefits of a Roth. You contributed to a traditional IRA,then realize it does not qualify for a tax deduction. So you recharacterize that money to your Roth IRA.
To recharacterize contributions, start by contacting the financial institution that is your IRA provider. Tell them how much money you’d like to recharacterize, and they will move that amount—along with any earnings or losses—over to the other type of IRA. The entire recharacterization process is done via a trustee-to-trustee transfer, so you don’t need to worry about withdrawing the money yourself. Your IRA provider will handle it all for you. Once your IRA provider completes the recharacterization, you can file your taxes as if you made the original contribution to the second account.
Recharacterization vs. Conversion
A recharacterization of an IRA is not the same as a conversion, although both strategies move funds from one type of IRA to another. Here are some of the key differences: Roth IRA conversions, on the other hand, are for people who want to convert tax-deferred retirement funds into a Roth IRA so they can make tax-free withdrawals in retirement. Conversions can happen at any time. They don’t have to be completed in the same tax year like recharacterizations do. You used to be able to “undo” Roth IRA conversions through recharacterization if your tax bill was higher than expected. However, this is no longer allowable under the Tax Cuts and Jobs Act. If you are considering moving funds from one IRA to another, consider speaking with a tax professional about which strategy is right for you. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
