In most of life, the terms "conversion" and "recharacterization" are roughly synonyms. They both refer to the process of changing one thing into another. This is true for IRAs as well, but the definition is much more specific. Conversion and recharacterization refer to the transition from a traditional IRA to a Roth IRA -- and back again -- and each involves specific rules and tax consequences.
IRA Rules Influencing Conversion and Recharacterization
There are two types of IRAs: Roth and traditional. The traditional IRA is the oldest, and is a deferred-tax account. In most cases, participants deposit money into the account and deduct the value of their contributions from their taxes, deferring taxes on that income and any earnings until they withdraw the money. At certain high income levels, participants cannot take a tax deduction for their traditional contributions, but they can defer tax on the earnings. These are known as "nondeductible contributions." Roth IRAs are similar to traditional nondeductible contributions, since participants pay taxes on the contributions as they deposit them. The difference is that Roth participants never have to pay tax on earnings they withdraw, as long as the withdrawals meet IRA guidelines. Both traditional-deductible and Roth IRA guidelines have specific income limits -- participants' whose adjusted gross income exceeds certain amounts are ineligible for these types of contributions.
Traditional IRAs existed for several years prior to Roth IRAs. When Congress created the Roth IRA, they put rules into place that allowed traditional IRA owners to convert their savings into the new IRA type. These rules are still in place, and as of the time of publication, they allow all traditional IRA owners to make conversions -- even those whose income is too high for standard Roth contributions. Since Roth IRAs are taxed accounts, IRA owners must pay tax on all deductible contributions and all earnings when they move money from a traditional account into a Roth account. Once the conversion is complete, earnings in the new Roth IRA grow tax-free. IRA owners can convert as much or as little of their traditional accounts to Roth accounts as they'd like in any given year, as long as their contributions are at least one year old -- you can't make a traditional contribution and convert it in the same tax year.
Recharacterization is the IRS equivalent of an "undo" button, and allows IRA owners to move a contribution or conversion from a Roth IRA back to a traditional account. As of the time of publication, there are two reasons to recharacterize: ineligible contribution and overly large tax burden. If you make a Roth contribution during the year and later discover your income is over the annual limit, you can recharacterize that contribution and move it into a traditional IRA instead. In a similar vein, if you convert your traditional IRA to a Roth and discover that the conversion tax is more than you want to pay, you can undo all or part of the conversion. You must complete a recharacterization for the same tax year as you made the original conversion or contribution. Practically speaking, this means you have until the October 15 extended tax filing deadline to get all your accounts in order.
Rollovers and 401k Plans
To be clear, neither a conversion or a recharacterization is a rollover. Rollovers are transfers between like-style IRAs or between an employer-sponsored plan like a 401(k) and an IRA. You might see conversions between employer-sponsored plans and IRAs when one plan is a traditional-style and the other is a Roth, and you can see both conversions and recharacterizations within a 401(k) plan that offers both traditional and Roth components. In any case, the terms refer to the same process -- a change in the tax framework surrounding the savings plan.
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