You may already be familiar with IRA conversions, and are well aware that these are allowed. You can convert your Traditional IRA into a Roth IRA just fine; and most investors do this because of the thought that a Roth IRA will be more advantageous so they will enjoy all the tax-free growth and tax-free distributions upon retirement. However, what if the converted Roth IRA accounts are now worth less by the time the account holder converts them? It is normal to make mistakes, however in this case, your actual money and investments are at stake!
The question is: do you still have the chance to correct such a mistake, without sacrificing your investments, and without suffering too much taxes?
The good news is that you can! And this is referred to as an IRA do-over. The Internal Revenue Services (IRS) refers this as “re-characterization”, which allows the account holders to reverse an IRA conversion under various circumstances. As a matter of fact, recharacterization does not only apply to conversions alone, but it also applies to contribution which the investors want to “do-over”.
Overview: Do-Over for Contributions and Conversions
There are several reasons why you may be thinking about an IRA do-over or IRA recharacterization. Lets take a look at a few different scenarios for when a recharacterization would be a good idea:
- You are making contributions to a Traditional IRA and then you decide to switch to a Roth IRA in order to maximize your IRA.
- You invest into a Roth IRA but then earn more income after a few years which is beyond the maximum income limits which then makes you unqualified for the Roth IRA plan, so you decide to transfer over to a Traditional IRA.
- You converted all or part of your Traditional IRA to a Roth IRA, but then the market fell after the conversion, and so you decide to reconvert at a lower balance to minimize the tax bill.
The rules of re-characterization allow the account holders of IRAs to reverse the transactions and still re-characterize any earning on the contribution — no matter what the reason; no need for any explanation. In IRS terms, an account holder needs to re-characterize the conversion in order to undo it, so to avoid paying the tax bill for the conversion or to get refunded if the tax was already paid.
How to Do-Over an IRA?
The process of an IRA Do-Over is just as simple as the process on how to open a Roth IRA. You need to contact your Roth IRA custodian and tell him that you want to re-characterize your account back to the Traditional IRA. It helps to look for the best IRA company to use before deciding to switch the account.
For already paid conversion taxes, you’ll need to file the amended returns to get refunded. You may also opt to re-characterize only part of the account, as this does not need to be done with the entire balance of the account. However, the rules and requirements to qualify for a re-characterization can get even more complex especially with partial re-characterization, so make sure you speak with your financial institution regarding your specific account and requirements.
Basic Re-characterization Rules to Remember
- You can recharacterize a contribution or conversion no later than the income tax filing deadline, plus the extension (if any), for the tax year of the conversion.
- Recharacterizations for conversions from Traditional IRA to Roth IRA is not allowed to convert the account back to a Roth until the next calendar year after the original conversion, and this must not be done before the 31-day period after the re-characterization has lapsed.