By Denise Appleby,CISP, CRC, CRPS, CRSP, APA. | LinkedIn
If you convert assets to a Roth IRA, you will owe income tax on any pretax amount of the conversion. But, if you change your mind, you can cancel that tax bill by reversing the Roth conversion. This reversal is referred to as a recharacterization.
If a conversion is recharacterized properly, it is treated as if it was never done for income tax purposes. This means that no income taxes would be owed on the amount, and the amount would be restored to your non-Roth IRA. But a recharacterization only works if it is done timely and properly.
A recharacterization must be done by your tax filing due date plus extension. If you file your tax return by the due date, you receive an automatic six-month extension.
This means that you would have until October 17, 2016 to recharacterize a Roth conversion that was done in 2015.
The Recharacterization Process
You must notify your IRA custodian before the deadline if you want a conversion to be recharacterized, in order to give the IRA custodian sufficient time to get it done by the deadline.
Your IRA custodian will likely have special paperwork that must be completed in order to have a conversion recharacterized. That paperwork will likely request information such as the date when the conversion was processed, the conversion amount, and any earnings or losses attributable to the conversion.
These earnings or losses are referred to as net income attributable (NIA). Some IRA custodians will calculate the NIA. If your IRA custodian will not calculate the NIA, then you might want to consider asking your tax professional to perform the calculation. The IRS provides an explanation of how the calculation should be done in IRS Publication 590-A, which is available on their website www.irs.gov.
Partial Recharacterization Allowed
If you prefer, you can choose to recharacterize only a portion of your conversion amount, instead of recharacterizing the full amount. This might be a good option, if you want to limit your conversion to an amount that will not put you in a higher tax bracket.
You Don’t Need a Reason
A recharacterization can be done for any reason, but it is often recommended when the converted amount has lost significant market value. For instance, assume that you converted $100,000, which has since lost market value and is now worth only $50,000. Your tax professional might recommend the recharacterization to prevent you from owing income tax on $100,000, when only $50,000 is left of the amount.
You can also recharacterize a conversion if you find that you cannot afford to pay the tax bill that is due.
Or, you can recharacterize a conversion because you simply changed your mind and no longer want to have the amount converted.
You Might Need to Amend Your Tax Return
If the full amount of the conversion is recharacterized, it is not required to be reported on your tax return. If only a portion of the conversion is recharacterized, then it should be reported on your tax return.
If you already filed your tax return and reported the conversion, you will need to file an amended return to report the recharacterization.
Proper Procedure is Key
Reversing or recharacterizing a Roth conversion is one of the few instances in which American taxpayers can change their minds about choosing to process a taxable transaction. But, it is effective only if it is done properly.
If you are considering recharacterizing a Roth conversion, be sure to contact your IRA custodian about their procedures and documentation requirements.