A Second Chance at IRA Contributions

Question: My wife and I put money into Roth IRAs last year. But we just completed our tax return last week and found out that we earned too much to make a Roth contribution. What to do?

Answer: Running afoul of the IRS is never an appealing prospect, but you don't have to worry. The tax code includes an amazingly generous provision that lets investors do over their IRAs through a process called recharacterization. So if you opened a Roth IRA and found out that your income was too high for you to qualify for the contribution in the first place, you can recharacterize your contribution as a traditional IRA contribution instead. Individuals who converted traditional IRA assets to Roth can also recharacterize back to traditional IRAs. (More later about other recharacterization scenarios.)

You won't be able to deduct your contribution to the traditional IRA because the contribution limits are even lower for deductible traditional IRA contributions than they are for Roths. (For 2011, married couples filing jointly cannot make a Roth contribution if they earn more than $179,000, and that limit is $110,000 for deductible IRA contributions if one partner is also able to contribute to a company retirement plan at work.) But you will be on the up and up with the Internal Revenue Service--always a good thing. And if you so choose, you can convert your traditional IRA assets to a Roth at a later time. (If you opened a Roth IRA in the first place, my guess is that this will be an appealing prospect. You'd just need to wait until the later of either: the tax year following the tax year of the original conversion--for example, 2011 for conversions made in 2010; or 30 days following the recharacterization.)

Your brokerage firm or mutual fund company should be able to coach you on the specific paperwork to fill out; you'll have to fill out a recharacterization form as well as a form for a new IRA.

That's all pretty straightforward, but there are a couple of wrinkles. First, if you have earnings on your initial Roth contributions, you'll need to recharacterize those as well--once you do the recharacterization, both your original contribution plus any investment earnings will now be part of your new traditional IRA. If you've lost money since you made your contribution, you'll just recharacterize the amount you have in the IRA at the time of the recharacterization, not the original contribution amount.

The other big wrinkle is time. The deadline for recharacterizing your IRA assets is the tax-filing deadline for the tax year in which you made the contribution. You can also take advantage of the IRS' automatic extension provision. So if you made your contribution in 2010, you have until Oct. 17, 2011, to recharacterize your IRA assets from a Roth to a traditional plan. If you recharacterized after you'd already filed your tax return for the year in which you made the contribution, you'd also have to file an amended tax return.

There are other situations when recharacterizations can come in handy. One of the key ones is if you converted some or all of your traditional IRA assets to Roth status and have seen the account drop in value. To use a simple example, say you converted a $100,000 traditional IRA balance to a Roth and paid $25,000 in taxes because you were in the 25% tax bracket. If the account value subsequently drops to $75,000, you could recharacterize back to a traditional IRA, then convert again. But this time you would owe just $18,750 ($75,000 times 0.25) in taxes at the time of the conversion. The same logic would also hold if you found yourself in a lower tax bracket than when you made the conversion. You could recharacterize back to a traditional IRA, then convert later on to take advantage of your lower tax bracket.

A recharacterization can also make sense if you converted to a Roth but later found out that the tax consequences were more onerous than you expected--perhaps you owed a lot more than you thought you would, or you accidentally disqualified yourself for credits and deductions for which you would normally qualify. You can recharacterize back to a traditional IRA, using the guidelines outlined above.

Finally, bear in mind that a recharacterization doesn't just have to move the assets from a Roth to a traditional IRA. You can also recharacterize from a traditional IRA to a Roth, assuming you meet the income limits for Roth contributions. Partial recharacterizations are also a possibility.

A version of this article appeared April 20, 2010.

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