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IRA Characterizations – Some Things You Must Know

Retirement planning is one of the most important aspects of financial planning. Since retirement is a time where you no longer have a steady income from a job, you require a saving blanket to rely on. Investing in the right instruments from an early age can help you create a pool of money that can support your expenses in your golden years. An Individual Retirement Account (IRA) is one such option. The IRA is a retirement savings tool. It offers tax saving along with adequate returns that can help you build a retirement corpus. There are different types of IRA accounts and you may like to explore each, based on your income and tax liability. However, IRAs come with a set of contribution limits, taxation rules, withdrawal protocols, and recharacterization criteria, etc.

This article talks about the recharacterization of the IRA and some things that you must know before you rollover or recharacterize your IRA:

  1. How many types of IRAs are there?
  2. Before proceeding to the recharacterization rules, it is important to know that there are different types of IRAs that you can choose from, depending on your needs. Primarily, the IRA is categorized as:

    • Traditional IRA: If you invest in a traditional IRA, your contributions are tax free and you pay taxes on your withdrawals in retirement.
    • Roth IRA: If you invest in a Roth IRA, you pay taxes on your contributions and your withdrawals are tax-free in retirement.

    The tax treatment of both these types of accounts is the major point of distinction between them. If you expect a lower income in retirement, you can consider a traditional IRA. With a lower retirement income, your taxes will also be reduced. You will pay your taxes at the current tax rate based on your present taxable income. However, if you expect a higher income in retirement or wish to lower your tax liability later, a Roth IRA may be more suitable. With a Roth IRA, you will enjoy tax free withdrawals that can result in a better financial status when you are older.

  3. What is an IRA recharacterization?
  4. Recharacterization refers to transferring your funds from a Roth IRA back to a traditional IRA or vice versa. This is not the same as an account rollover. An account rollover is when you transfer the assets held in a traditional IRA, Rollover IRA, SEP-IRA, SIMPLE IRA, SARSEP IRA, 401(k), 403(b), 457(b), etc. to a Roth IRA. However, if you wish to undo your IRA rollover, you need to do this with an IRA recharacterization.

  5. How do you recharacterize an IRA?
  6. The recharacterization must be done before the income tax payment deadline for the year you make the recharacterization. If you want to recharacterize an IRA contribution, you need to contact the trustee of the financial institution that is holding your IRA, also known as your IRA custodian, and request them to transfer the contribution along with the earnings to the new IRA. The income tax payment deadline also includes the extensions. This means that if you file your tax return by April 15, you will be given an extension for 6 months. So, the deadline to recharacterize your IRA will automatically shift to October 15 of the said year. A crucial thing to know here is that the recharacterization is calculated as per the value of stocks and not the number of stocks. This implies that if you convert 50 shares of a particular stock and then recharacterize it, the recharacterization will be done in dollars and not as per the quantity of stocks. For 50 stocks that cost $1,000, the recharacterization request is made on $1,000 and not on 50 stocks.

  7. Why do investors recharacterize an IRA?
  8. There can be several reasons why you may want to recharacterize your IRA. When you convert your assets, the tax is calculated on the value of your assets at the time of the conversion. So, if the value of your assets was $5000 at the time of conversion, but later dropped to $2500, your tax will still be computed on $5000 and not $2500. This can be a cause of concern as you end up paying more tax than you gain in returns.

    Some common reasons why you may want to recharacterize your account include:

    • The value of your assets has dropped after you made the conversion.
    • The conversion was not successful.
    • You regret your decisions and no longer want to keep a Roth account.

  9. How to calculate the earnings or losses in an IRA recharacterization?
  10. The earnings made or the losses that your bear also need to be transferred along with the amount that is being recharacterized. There is a special formula that the IRS uses to calculate the earnings gained or losses incurred on the amount that you want to recharacterize on your IRA.

    Here is the formula: NI = C x (ACB − AOB) /AOB

    • NI stands for your net income
    • C stands for the contribution
    • AOB refers to the adjusted opening balance
    • ACB is the adjusted closing balance

    The period of computation takes into account the beginning period and the end period. In the case where your IRA is valued on a daily basis, the period of computation starts right before you make the contribution that is being recharacterized and ends after the contribution is complete. In other cases, the recent fair market value before you make the contribution and the most recent fair market value after the recharacterization are used. For instance, if you are recharacterizing your IRA in the month of February 2021 for a contribution that was made in November 2020, you will take the value at the end of your October 2020 statement as the beginning period and the January 2021 statement as the ending period to gauge the fair market value of your funds and ascertain your profits or losses.

  11. Can you make a partial IRA recharacterization?
  12. Yes, you can make a partial recharacterization if you do not want to recharacterize the entire amount in your IRA. You can also make a full recharacterization, depending on your needs. However, you would only need to calculate your earnings or losses in case of a partial recharacterization. A full recharacterization does not require this computation.

  13. How do you report tax on your IRA recharacterization?
  14. If you opt for a partial recharacterization, you need to report the same to the IRS. This can be done with Form 8606. You only need to submit this form in case of a partial recharacterization and not in case of a complete recharacterization.

    In addition to this, the financial institution holding your assets will also use Form 5598 to report your IRA contributions that are being recharacterized. You will receive two forms. One is for the contribution that was initially made and the second for the funds that were recharacterized to the new IRA.

    In addition to this, you will receive a Form 1099-R for the initial contribution. The IRA custodian needs to use this form to show your recharacterization. There is a special code in Form 1099-R in Box 7 that your custodian will highlight to mark your recharacterization, so that you are not taxed.

  15. Some important things to remember:

Here are some things to note when opting for recharacterizing your IRA:

  • If you recharacterize a Roth IRA back to a traditional IRA, any taxes owed on the amount are removed.
  • The gains or losses incurred on the recharacterized funds are not subject to any tax. While there are tax forms that you need to report your recharacterization to the IRS, there are no additional taxes charged on the amount at the time of recharacterization. Your funds are considered as if they were still in the IRA.
  • If you convert your employer sponsored plan, such as a 401(k) retirement account to a Roth IRA and recharacterize the contributions, the funds are moved to a Traditional IRA and not the employer sponsored plan.
  • If you are taking required minimum distributions (RMDs), the recharacterized funds are added to the previous year’s account balance.
  • You can only recharacterize your funds once a year. If you want to convert your recharacterized funds again, you need to wait for 30 days from the date of recharacterization, or the next year from the recharacterization, whichever is longer.

To sum it up

IRA recharacterizations are a great option if you want to undo your IRA rollover. They offer a way out of a bad tax situation that you may not have anticipated earlier. However, they can be a bit cumbersome with the calculations involved and can only be opted for one time in a year. Hence, it may be advised to fully understand the repercussions of an account rollover before you make a call.

It can also help to consult a professional financial advisor to know how rollovers and recharacterizations work to make things easy and hassle free for you to reach your retirement goals.

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