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Recharacterizing An IRA Contribution Or Conversion

Tax filers sometimes have a change of opinion concerning their investment choices. Many decisions become final at the end of a tax year, but there is some additional flexibility in individual retirement accounts. Individuals who initially select between a traditional IRA or a Roth IRA can timely change their mind and reverse their choice of IRA type.

You may have converted a traditional IRA to a Roth IRA before realizing that you actually prefer keeping the funds in the traditional IRA. On the other hand, you may have developed reservations about your decision to contribute to a traditional IRA instead of to a Roth IRA. Fortunately, either IRA choice can be reversed by recharacterizing the account type in a timely manner.

Not a rollover

A recharacterization is not a rollover. Tax filers are limited to one IRA rollover per year, but a recharacterization does not count against the rollover limit. A recharacterization essentially reverses the initial IRA choice and moves the funds into the preferred type of account. The net result is the same as if the original account type had not been selected.

Retrospective planning advantage

Your choice of IRA type can be changed up until the due date of the tax return for the applicable year. An additional six months is available to recharacterize an IRA if your tax return for the year is filed by its due date. As a result, an IRA contribution made near the beginning of one tax year can be recharacterized up until the latter portion of the following year.

Recharacterization provides an opportunity to allocate IRA contributions in a manner that optimizes your tax benefit. An IRA recharacterization must be a direct transfer from trustee to trustee. If both accounts are held by the same institution, a recharacterization may entail as little as an internal transfer within the organization.

Income tax forms

It is important to clearly notify both financial custodians of your intent to recharacterize the IRA. You will likely receive IRS Form 1099-R from the institution in which you originally placed the funds, essentially reporting a distribution. Form 1099-R contains an entry box in which the trustee includes specific codes to designate the distribution as a recharacterization, rather than an early withdrawal.

You may need to file IRS Form 8606 with your Form 1040 if the recharacterization results in a nondeductible contribution to a traditional IRA. If Form 1040 is filed before the IRA is recharacterized, an amended tax return can be filed to report the change. Contact an accountant for more assistance in financial planning.