Welcome to the New Morningstar.comSee what's new
Advisor Insights

Where Recharacterization Is Alive and Well

Natalie Choate

Save this column. Someday you will have a client who needs this remedy.

Since 1998 (when Roth IRAs were invented), Section 408A(d)(6) of the Internal Revenue Code has permitted a taxpayer to "recharacterize" his or her IRA contribution. A contribution to a Roth IRA could be "recharacterized" as a contribution to a traditional IRA and vice versa.

The primary (some assumed the sole) purpose of recharacterization was to permit taxpayers to change their minds about Roth conversions. If you converted your traditional retirement plan to a Roth IRA, then later regretted it, you could undo the conversion. All you had to do was move the converted amount (plus earnings it had accrued while living in the Roth IRA) over to a traditional IRA no later than the extended due date of your tax return for the conversion year.

The Tax Cuts and Jobs Act of 2017 eliminated that do-over option for Roth conversions. After 2017, you can no longer reverse a Roth conversion.

But recharacterization is still alive and well for other uses. The law still says (as it has said all along) that any IRA contribution can be recharacterized by transferring the contribution (plus earnings thereon) to a different IRA by the due date ("including extensions") of the tax return for the contribution year--except as the IRS may otherwise provide through regulation and (now) except for Roth conversion contributions. By regulation, the IRS has forbidden the recharacterization of a tax-free rollover contribution--and that's all. So recharacterization is still alive and well for fixing certain mistakes and in some cases changing your mind about an IRA contribution.

Here are two examples of how recharacterization can (still) be used in 2018 and beyond.

Erin, age 45, made a $5,500 contribution to a Roth IRA in 2017. She later discovers her 2017 income ($150,000) was in excess of the maximum income permitted for a single filer to be eligible to contribute to a Roth ($133,000). By the time she discovers this, in June 2018, the Roth IRA has grown to $6,300. She moves the entire $6,300 by IRA-to-IRA transfer (not "rollover"!) into a traditional IRA by the applicable deadline (see below). Her Roth IRA contribution has been properly "recharacterized" as a traditional IRA contribution, which she is permitted to make. She has undone the illegal Roth IRA contribution.

Daryl retired in 2017 from Acme. He had a designated Roth account in the Acme 401(k) plan. He directed the plan to transfer his $75,000 designated Roth account balance, by direct rollover, into his Roth IRA at financial institution. Through errors made by the Acme plan administrator and/or financial institution, the money was deposited in Daryl's traditional IRA instead of his Roth IRA. It is illegal to roll over or transfer designated Roth account money into a traditional IRA--so that was not a valid rollover. If nothing is done to correct the error, the Acme plan distribution will be treated as a distribution to Daryl, and the invalid "rollover" contribution will treated as an excess contribution to the traditional IRA. How can Daryl fix this?

There are two potential pathways to fix the mistake--rollover and recharacterization. 

To use rollover, Daryl would have to first withdraw the $75,000 excess contribution from the traditional IRA together with its earnings (let's say that's $1,0000 no later than the extended due date of his tax return. That would cure the excess IRA contribution. Then he would deposit the contribution amount (but not the earnings) into the correct account (the Roth IRA). If the deposit into the Roth IRA occurs more than 60 days after the original distribution from the Acme plan, Daryl would self-certify to the IRA provider that the reason for lateness was financial institution error. This would make him eligible for the late rollover under IRS Revenue Procedure 2016-47. (For more on this, see my Morningstar column from September 2017).

Another way to cure the mistake is recharacterization. Daryl can "recharacterize" the illegal Acme-plan-to-traditional-IRA "rollover" contribution as a valid legal rollover contribution to the Roth IRA. This does not violate the prohibition against recharacterizing tax-free rollovers, because the transfer from the Acme designated Roth account to the traditional IRA was not a valid rollover.

Recharacterization has two advantages over rollover as a correction method. First, with recharacterization, Daryl can move (must move) the earnings as well as the original contribution over to the correct IRA. With a rollover, you can only roll over the original distribution amount--not any earnings it might have accrued while it was "living" in the wrong IRA. Second, recharacterization has a longer deadline (extended due date of tax return) than a rollover (generally 60 days).

Now about that "extended due date" deadline: When an election or action must be made no later than the due date of the taxpayer's tax return "including extensions," that has a special meaning under IRS regulations. If you file your tax return on time then (for purposes of this deadline) you are "deemed" to have been granted an extension of your tax return due date--even if you didn't request an extension. So if you obtain an extension of time to file until Oct. 15, then file by that deadline, your recharacterization deadline is Oct. 15. But even if you don't obtain any extension of time to file, if you file your tax return by April 15 ("on time"), your "extended due date" deadline for recharacterization is still Oct. 15.

Where to read more: Regarding the recharacterization option and limitations thereon, see Internal Revenue Code § 408A(d)(6) and Treas. Regs. § 1.408A-4, A-3(a), § 1.408A-5, A-10, Examples 2, 3, and 4, and § 1.408-8, A-8(b). For how to compute "earnings" that must be transferred along with the recharacterized contribution and the meaning of "extended due date" of the tax return, see Natalie B. Choate's downloadable Special Report: IRA Mistakes and How to Fix Them, available at www.ataxplan.com.

Natalie Choate will be speaking at a location near you if you live in Chicago, IL (4/30/18); Wilmington, DE (5/9/18); Bethlehem, PA (5/10/18); Waltham, MA (6/1/18); or Albany, NY (9/25/18). See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.