Contributed by: CoryF FreeTaxUSA Agent, Tax Pro
Did you ever contribute to an individual retirement account (IRA) and later realize it might have been better to choose a different type of IRA? Or perhaps your Roth IRA contribution is facing penalties due to high income? If either situation applies to you, recharacterizing your IRA contribution could be the solution.
What is a recharacterization?
Recharacterization is like a financial “do-over.” It allows you to correct mistakes or optimize your retirement savings strategy. Here are the two main reasons for recharacterizing:
- Fixing contribution mix-ups:
- Imagine you accidentally contributed to the wrong type of IRA (e.g., traditional instead of Roth). Recharacterization lets you “fix” it.
- For instance, if you made a traditional IRA contribution but meant to contribute to a Roth IRA, recharacterization can set things right.
- Dealing with Roth IRA income limits:
- Sometimes your income exceeds the limit for Roth IRA contributions. Recharacterization allows you to switch to a traditional IRA.
- The reverse is also true: you can recharacterize from traditional to Roth if your income allows.
How does a recharacterization work?
Transfer of funds
- Notify your IRA custodian about your intention to recharacterize.
- Transfer the contribution amount (plus any earnings) from the original IRA to the new IRA designated for the recharacterized contribution.
Reporting:
- Use FreeTaxUSA to report the contribution as initially made.
- Indicate that the contribution was recharacterized.
- Provide dates for the initial contribution and recharacterization, and a reason for making the recharacterization.
Form 1099-R:
- The IRA custodian issues a Form 1099-R for the year of recharacterization.
- Taxable income is generally limited to earnings before recharacterization.
- If recharacterization occurs in the same calendar year as the contribution, you’ll receive the 1099-R early next year. Otherwise, amend your current year return when it’s issued.
Dealing with excess contributions
- If you accidentally over-contributed to a Roth IRA, you’ll face a 6% penalty annually until corrected.
- Recharacterizing to a traditional IRA removes the excess and penalty.
- After recharacterization, consider a Backdoor Roth IRA conversion if desired.
Notice
Before committing funds or recharacterizing IRAs, know your estimated or actual modified adjusted gross income (MAGI). This ensures a successful recharacterization.
Happy investing, and remember these recharacterization rules as your safety net!
See also "How do I report a backdoor Roth".
