Recharacterization Rules for a Roth IRA Conversion

by Dale Bye

Most investing decisions come with a no-refund, no-exchange policy, but the IRS allows for buyer's remorse if you converted all or part of a traditional IRA into a Roth. You even can wait until you see your tax bill before deciding whether to undo a conversion. The IRS calls this second chance a "recharacterization," and it has precise rules to follow.

Timing

The conversion must be completed by Dec. 31 of the tax year, but your recharacterization doesn't need to be completed until your tax-filing deadline. That's April 15, unless you file for an extension, which would give you until October 15 to reconsider.

Recharacterization Made Simple

If your conversion was made into a new Roth IRA account with no other assets, you can undo the conversion by simply returning all the converted assets to your traditional IRA. The 1099-R you receive covering the conversion will be overridden by a Form 5498 from your Roth administrator detailing your recharacterization.

Recharacterization From Blended Account

If you converted the IRA assets into an existing Roth, the recharacterization mechanics are trickier. The IRS mandates that you adjust the recharacterization to account for investment performance, and the adjustment must be based on the returns of the entire account. For example, you convert $10,000 in assets into an account that already contains $20,000 in assets. Now, assume your converted assets drop in value by 20 percent and the previous assets by 10 percent. Your new account balance would be $26,000, a 13.3 percent decrease overall. To recharacterize the original $10,000, you must return $10,000 minus 13.3 percent -- $8,670 -- to your traditional IRA. Because your converted assets are now worth only $8,000, you must move $670 of the original after-tax Roth assets as well -- and, yes, you must pay tax on that $670 again, either when you convert it back to the Roth later or when you take a distribution from your traditional IRA.

Contributions After Conversion

If you make a regular annual contribution to the Roth IRA after you made the conversion, the contribution is treated much the same as the assets in a blended account. Any recharacterization must account for the investment performance of the contribution as well as the converted assets.

Partial Recharacterization

You can opt to recharacterize only a portion of your conversion. Let's say you convert $20,000 but later decide to recharacterize half of that to lower your tax bill. You must account for investment returns as you would with a recharacterization from a blended account. If the conversion was made to a new Roth account, you simply have to recharacterize half the assets. If the recharacterization is from a blended account, you must account for the entire account, including any contributions. Partial recharacterizations must be reported on IRS Form 8606.

Reconversion

After a recharacterization, you must wait 30 days before you can make a conversion from the IRA that received the recharacterized assets. You also are not allowed a conversion from that account in the same year as your original conversion. But if you open a new account to receive the recharacterized assets, that will be the account the IRA subjects to the holding period. You can convert assets from another traditional IRA immediately, including the account from which you made the conversion that you recharacterized.

About the Author

Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.

Photo Credits

  • Stockbyte/Stockbyte/Getty Images