Deciding on your retirement savings strategy can be difficult. You have access to a wide range of resources and strategies, which you can undo if you make a mistake. Â.
For this reason, you ought to understand the distinction between Roth conversions and recharacterizations to make informed choices about your IRAs. When comparing a Roth conversion vs. recharacterization, you have to take your overall retirement objectives, financial situation, and tax status into account.
No, a Roth conversion made on or after January 1, 2018, cannot be recharacterized. This means you cannot undo a Roth conversion and move the funds back to a traditional IRA. However, you can still recharacterize an IRA contribution from one type of IRA to another.
Understanding Roth Conversions and Recharacterizations
Roth conversions involve moving funds from a traditional IRA to a Roth IRA. You pay taxes on the converted amount in the year of conversion, but future withdrawals are tax-free.
Recharacterizations allow you to change the designation of your IRA contribution from a Roth IRA to a traditional IRA or vice versa. This option was available for Roth conversions made before January 1, 2018, but is no longer allowed.
Reasons for Recharacterization
Previously, people recharacterized Roth conversions for various reasons, including:
- Changes in tax situation: If your income decreased after the conversion, recharacterizing could lower your tax bill.
- Market downturn: If the market declined after the conversion, recharacterizing could protect your investment from further losses.
- Contribution errors: If you accidentally contributed to the wrong type of IRA, recharacterization could correct the mistake.
Alternatives to Recharacterization
Since recharacterizing Roth conversions is no longer possible, consider these alternatives:
- Backdoor Roth IRA: This strategy allows high-income earners to contribute to a Roth IRA by first contributing to a traditional IRA and then converting it to a Roth IRA.
- Traditional IRA contributions: If you are eligible, you can continue making contributions to a traditional IRA and deduct them from your taxes.
- Tax-loss harvesting: If the market declines, you can sell losing investments in your Roth IRA and repurchase them later to offset capital gains.
Important Considerations
- Tax implications: Recharacterizations may have tax implications, so consult with a tax professional before making any changes.
- Deadlines: Recharacterizations must be completed by the tax filing deadline for the year of the original contribution.
- Reporting requirements: You will need to report recharacterizations on your tax return using IRS Form 8606.
While recharacterizing Roth conversions is no longer an option, several alternatives can help you achieve your retirement savings goals. Carefully consider your financial situation and tax implications before making any decisions.
Frequently Asked Questions
Can I recharacterize a Roth IRA contribution?
Yes, you can still recharacterize an IRA contribution from a Roth IRA to a traditional IRA or vice versa. However, this option is only available for contributions made before January 1, 2018.
What are the benefits of recharacterizing a Roth IRA contribution?
Recharacterizing a Roth IRA contribution can help you avoid paying taxes on the earnings if the market declines after the contribution. It can also allow you to deduct the contribution from your taxes if you are eligible.
What are the tax implications of recharacterizing a Roth IRA contribution?
Recharacterizations may have tax implications, so consult with a tax professional before making any changes.
What is the deadline for recharacterizing a Roth IRA contribution?
Recharacterizations must be completed by the tax filing deadline for the year of the original contribution.
How do I report a recharacterization on my tax return?
You will need to report recharacterizations on your tax return using IRS Form 8606.
Additional Resources
How to Calculate Your IRA Recharacterization
Determine your gains and losses prior to recharacterizing an IRA contribution. You can compute this using the straightforward formula provided by the IRS:
It is important to remember that the calculation period begins the moment you decide to contribute to your IRA. This period ends immediately when you make the recharacterization. In the absence of a daily assessment, your IRA will calculate gains and losses using the fair market value. Â.
When you file your tax return, mistakes in tax reporting for a recharacterization could land you in hot water with the IRS. To ensure accurate calculations and to understand the impact of your decisions, you should collaborate with tax professionals.
What is the difference between a Roth Conversion vs a Recharacterization?
Transferring tax-deferred money from a retirement plan to a Roth IRA is known as a Roth conversion. You are moving money to a Roth IRA from a tax-deferred retirement account. These tax-deferred accounts come in the form of SEP, simple, and traditional IRAs. Â.
With a Roth IRA, you pay taxes up front but can take tax-free withdrawals. With this strategy, you can make conversions directly or indirectly.
A recharacterization is something different. It is possible to convert your IRA from a Roth to a traditional account or the other way around. This switch can be used as an undo button in the event that you decide against converting. Remember that recharacterizations are reversible for a maximum of one year.
You can quickly undo a conversion from a Roth IRA to a traditional IRA with recharacterizations of traditional or Roth IRAs. After making a contribution, you can also use a recharacterization to change the type of IRA. You can convert your contributions to a traditional IRA if you make a contribution to a Roth IRA and later decide you want to change your mind.
Recharacterizations may be pursued for a variety of reasons, such as a reduction in the value of the converted investment or alterations in your tax situation. The converted or contributed amount is transferred to the original account during a recharacterization, as though it had never occurred. This also includes any associated gains or losses.
For illustration, suppose you contributed to a traditional IRA and your income was higher than the cutoff for Roth contributions. If your income is less than anticipated, you might want to use a Roth IRA. You could treat the initial contribution as a Roth IRA contribution by recharacterizing it.
One may wonder what the distinction is between a conversion and a Roth recharacterization. Since the Tax Cuts and Jobs Act of 2017, conversions from a Roth IRA cannot be undone. It follows that while a Roth conversion cannot be recharacterized, contributions to a Roth IRA can.