This video was created and submitted by Robert W. Baird & Co. and selected for publication on Morningstar.com by Morningstar editors.
What is a Roth Recharacterization?
Tim Steffen: A Roth recharacterization is essentially the "un-doing" of a Roth conversion. It allows the taxpayer to return the funds they converted back to their Traditional IRA, thereby avoiding the income tax liability associated with the conversion.
Why might someone consider a Roth recharacterization?
Steffen: The IRS doesn't require taxpayers to identify a reason for a Roth recharacterization, and there are several scenarios in which a recharacterization might be appropriate. The most common occurs when the value of a conversion has declined. For example, let's say an investor converted $25,000 from their Traditional IRA to a Roth. And let's say subsequent investment performance reduced the value of the Roth to $20,000. That investor will still pay taxes on the $25,000 – unless they do a recharacterization. After a recharacterization, it will be as if those funds had always remained in the Traditional IRA. The recharacterization won't recover the decline in investment value, but it does avoid the tax liability on the Roth conversion.
There are other common reasons for recharacterization. If the Roth conversion created a larger tax cost than you anticipated, you may want to recharacterize only part of the conversion, leaving a conversion amount in the Roth that leaves you with a tax cost you can afford.
A Roth conversion could trigger a loss of some deductions or credits, or cause other income such as Social Security benefits to be taxable.
If your state is one that doesn't tax withdrawals from retirement plans, moving money to a Roth may not be as tax advantageous.
Lastly, if you are already retired, you may find that the conversion had an adverse impact on Medicare premiums.
In any of these scenarios, calculating the recharacterization amount can be tricky – especially if you only recharacterize part of the original conversion, or if the original conversion was added to an existing Roth IRA that contained other investments. In those cases, be sure to work with a professional who understands how these calculations are done.
When is the deadline for a Roth recharacterization?
The deadline for a Roth recharacterization is October 15 of the year after the year of the original conversion. If you've already filed your tax return reporting the conversion to the IRS, don't worry – you can still do the recharacterization up to the October 15 deadline by filing an amended tax return for that year. If you do the recharacterization in the same calendar year as the conversion, the tax reporting can be much simpler. In either case, it's a good idea to work with an experienced tax preparer in these situations.
Are there other restrictions on recharacterizations?
The IRS does impose some restrictions on funds that are recharacterized from a Roth to a traditional IRA.
The recharacterized funds must stay in the traditional IRA until the longer of either thirty days from the date of the recharacterization, or January first of the year after the year of the original conversion.
However, this requirement does not prevent you from doing a new Roth conversion with other assets from the same Traditional IRA or even a different one.
Are there special considerations for 2010?
Roth conversions done in 2010 were eligible for a special election allowing the income from the conversion to be spread over tax years 2011 and 2012.
If you recharacterize your 2010 Roth conversion and then decide later to convert other funds to a Roth in 2011 or later, your conversion will be fully taxable in the year of conversion.
The two-year tax deferral only applied to conversions completed during 2010. Keep that in mind when evaluating recharacterization as an option.
For any other questions regarding a Roth recharacterization, including assistance with calculating the amount to move between accounts, please contact your Baird Financial Advisor and consult your tax advisor.