Making ineligible or unwanted IRA contributions are two mistakes individuals too frequently make. While the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the recharacterization of a Roth IRA conversion, TCJA did not eliminate the recharacterization of a Roth IRA contribution.
As will be discussed in this column, the recharacterization of an IRA contribution can be a valuable strategy for federal employees in order to correct any mistakes made in 2019 IRA contributions.
In general, a Roth IRA contribution can be recharacterized as a traditional IRA contribution or vice versa, provided that the recharacterized contribution is valid in its own right. A recharacterization can be made for any reason. In addition to making a recharacterization of an IRA contribution, a recharacterization can also be used when the wrong type of IRA mistakenly receives a rollover or transfer from a retirement plan such as the TSP.
Some examples why a recharacterization of an IRA contribution must be performed:
Example 1. James, age 52, is a single federal employee covered by FERS and whose 2019 modified adjusted gross income (MAGI) was $102,000. James contributed $7,000 to his deductible traditional IRA during 2019. As can be seen in the following table, James is not eligible to contribute to a deductible traditional IRA for 2019 because his 2019 modified adjusted gross income (MAGI) is above the MAGI limit and James is covered by a pension plan.
James can recharacterize the traditional IRA contribution to a Roth IRA provided he qualifies for a Roth IRA contribution; namely, his modified adjusted gross income is below the limit as shown below in the table.
Example 2. Sherry, age 45 and a federal employee, is married to Doug, age 47. During 2019, Sherry and Doug each contributed $6,000 to a Roth IRA. Sherry and Doug are not eligible to contribute to Roth IRAs during 2019 because their 2019 MAGI of $240,000 was too high, as shown below.
Sherry and Doug can recharacterize their 2019 Roth IRA contributions to nondeductible traditional IRA contributions. This is because Sherry and Doug are under age 70 and there are no income limitations for contributing to a nondeductible traditional IRA.
A recharacterization can be performed for major or minor reasons, including changing one’s mind about a retirement savings strategy. The only limitation is that an IRA owner has to be eligible to contribute to the type of IRA to which the funds are being recharacterized. For example, for 2019 an individual over age 70.5 cannot recharacterize a 2019 Roth IRA to a traditional IRA contribution because individuals over age 70.5 cannot contribute to a traditional IRA. This age restriction for traditional IRAs has been repealed as a result of the SECURE Act passage, but only for traditional IRA contributions made for 2020 and later years. A contribution cannot be recharacterized from one tax year to another.
How to recharacterize an IRA contribution
To recharacterize an IRA contribution, the contribution must be transferred from the first IRA (the IRA to which the contribution was originally made) to the second IRA in a direct (“trustee-to-trustee”) transfer and not in a rollover. The deadline for directly transferring to the second IRA is the due date (including extensions) for the tax return for the year in which the contribution to the first IRA was made. This means that for IRA contributions made for 2019 that have to be recharacterized, the deadline is October 15, 2020 (the deadline for filing 2019 federal income tax returns, including extensions).
The following are the three requirements that individuals must fulfill in order to perform a recharacterization of an IRA contribution:
- Instruct the trustee of the first IRA to transfer the contribution, as well as any net income allocable to it, to the second IRA. If there was a net loss, the net income transferred may be a negative amount.
- Report the recharacterization on their tax return for the year during which the contribution was made (see below on how to report a recharacterization).
- Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.
The IRA owner must notify both the trustee of the first IRA (the one to which the contribution was originally made) and the trustee of the second IRA (the one to which the contribution is being moved) that the IRA owner has elected to treat the contribution as having been made to the second IRA rather than the first IRA. The notifications must be made by the date of the transfer. Only one notification is required if both IRAs are maintained by the same trustee.
Some additional rules regarding IRA contribution recharacterizations
. No deductions allowed. The contribution to the first IRA cannot be deducted. Any net income transferred with the recharacterized contribution is treated as earned in the second IRA.
- Election to recharacterize cannot be changed. After the transfer to the second IRA has taken place, the election to recharacterize cannot be revoked.
- Year conversion is made. For recharacterization purposes, individuals who receive a traditional IRA distribution in one tax year and roll it over into a Roth IRA in the following year (but still within the 60-day rollover period) treat the contribution to the Roth IRA as it were made in the earlier tax year.
- Deceased IRA owners. The election to recharacterize can be made on behalf of a deceased IRA owner by the executor, administrator, or other person responsible for filing the decedent’s final income tax return.
Reporting a recharacterization
Individuals who elect to recharacterize a contribution to one kind of IRA (traditional or Roth) as a contribution to another IRA must report the recharacterization on their federal income tax return as directed by Form 8606 and its instructions. To the extent a contribution is recharacterized, it is treated as having been made to the second IRA. In addition, a statement that explains the recharacterization must be attached to the return for which the original contribution was made. The following table explains the reporting process:
When an individual recharacterizes an IRA contribution, the trustee of the first IRA must report the amount contributed before the recharacterization as a contribution on IRS Form 5498 and the recharacterization as a distribution on Form 1099-R. A 2019 Form 1099-R reporting the recharacterized amount is shown as a distribution in Box 7 of Form 1099-R using the following codes:
- Code N if the contribution and recharacterization both occurred in 2019; or
- Code R if the contribution was made for 2018 but not recharacterized until 2019.
The trustee of the second IRA is required to issue a Form 5498 reporting the amount received (fair market value) in Box 5 of Form 5498.