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Retirement Perspectives

Investors who convert to Roth IRAs still have time to change their minds and reverse or unwind the conversion through a process known as recharacterization.

Recognizing that mistakes sometimes happen, the tax code allows IRA accountholders to change their minds via a “do over” technique called recharacterization.

Recharacterization allows an individual to unwind or reverse a Roth IRA conversion. A Roth conversion triggers federal income and (if applicable) state income tax liability, whereas a recharacterization eliminates the tax liability altogether.

Anyone can bring about a recharacterization for any reason. However, there is a deadline rapidly approaching—Monday, October 16, 2017—that allows the recharacterizing of 2016 conversions and IRA contributions.  So, now is the time to contact clients who converted assets to a Roth IRA, in case they’re having second thoughts.

The October 16th deadline applies to recharacterizing a conversion done in calendar year 2016. This deadline applies even if taxes were filed in a timely manner—in other words, an individual can report a recharacterization via an amended 2016 tax return. An individual may be eligible for a refund if taxes were previously paid.

The custodian will transfer the funds along with any earnings/losses directly from the first IRA to a second IRA. Although this is a tax-free transaction, the transaction is reported to the IRS. In addition, the investor will receive a 2017 Form 1099-R  from the first IRA and a 2017 Form 5498 (box 4) from the second IRA.

Here are 11 tips for a seamless recharacterization:

1. Check with the IRA custodian(s) regarding the paperwork and process required to recharacterize.

2. Recharacterization is required to be processed via a “trustee-to-trustee” transfer.

3. October 16 is a hard deadline.  In other words, the recharacterization process must be finalized by that date.  We suggest contacting your IRA custodian regarding the timing of the recharacterization. Waiting until October 16 could prove problematic.

4. A full or partial recharacterization is permitted.

5. An individual is allowed to reconvert after recharacterizing. But certain timing must be followed: an individual must wait until the calendar year following the original conversion or more than 30 days, whichever is longer.

6. There may be an advantage to establishing a separate Roth IRA (conversion) for each individual investment. A Roth IRA contribution that is ineligible because a taxpayer’s income exceeded the Roth IRA income limit can be recharacterized to a traditional IRA contribution. The rules for this recharacterization generally follow most of the excess IRA contribution rules.

7. Whatever amount is recharacterized does not have to go back to the same IRA from which it originally came. Any traditional IRA is permitted.

8. A Roth conversion that was initiated from a qualified plan, such as a 401(k), cannot be recharacterized back to the plan. Instead, the funds would need to be transferred to a traditional IRA.

9. A conversion of a pretax 401(k) funds to a Roth 401(k) (not IRA) is not eligible for recharacterization; the transaction also is irrevocable.

10. As long as a maze of rules and deadlines are adhered to, an account owner can play the conversion/recharacterization/reconversion game indefinitely. 

11. Regulations permit post–death recharacterization by the executor of the accountholder’s estate.

Worried about extra paperwork? Partner with your CPA or tax professional, because reporting a rechacterization can involve multiple tax forms.

 

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