Pursuant to the Tax Cuts and Jobs Act of 2017 (TCJA), effective January 1, 2018 a conversion from a traditional IRA to a Roth IRA, or a transfer from a qualified retirement plan (and the Thrift Savings Plan) to a Roth IRA cannot be “recharacterized.”. But under TCJA individuals are still permitted to “recharacterize” IRA contributions.
This column discusses what a recharacterization is, and how it can benefit federal employees and annuitants who may have contributed to the wrong type of IRA for the year 2020.
What what is an IRA Recharacterization?
In simple terms, an IRA contribution recharacterization means changing a traditional IRA contribution is to a Roth IRA contribution or vice versa. In order to recharacterize an IRA contribution, the contribution must be transferred from the first type of IRA (traditional or Roth) (the IRA to which the original contribution was made) to the second IRA in a direct “trustee-to-trustee” transfer.
The deadline for making the transfer to the second IRA is the due date (excluding extensions) for the tax return for the year for which the contribution to the first IRA was made. This means that any IRA contribution made for the year 2020 must be recharacterized no later than October 15, 2021, the deadline (including the six-month extension) for filing 2020 federal income tax returns.
Why Recharacterize an IRA Contribution?
Why would an individual who made a traditional IRA contribution during 2020 want to recharacterize the contribution to a Roth IRA contribution?
A recent column, “Still Time for Federal Employees to Make 2020 IRA Contributions” discusses the three types of IRAs federal employees can contribute to for the year 2020. These IRAs are a traditional IRA (deductible and nondeductible) and a Roth IRA. The column explained that federal employees are subject to income limitations (their modified adjusted gross income or MAGI must be below certain limits) in order to contribute to a deductible traditional IRA and subject to another set of MAGI income limitations in order to contribute to a Roth IRA.
As an example of employee needing to perform a recharacterization of an IRA contribution, suppose an employee made a deductible traditional IRA contribution sometime earlier in 2020, but subsequently determined that the employee’s 2020 MAGI was too large. The employee is therefore not eligible to contribute to a deductible traditional IRA. However, the employee’s MAGI is below the limit for contributing to a Roth IRA. The employee therefore wants to recharacterize the 2020 IRA contribution from a traditional IRA to a Roth IRA.
Another example of needing to recharacterize an IRA contribution is the example of aa employee who contributed to a Roth IRA earlier in 2020 but now discovers that he or she anticipates a huge federal tax liability for 2020.
The Roth IRA offers no current tax savings while a deductible traditional IRA (in which the contributions are an “adjustment to income” on the employee’s 2020 federal income tax return) results in current federal income tax savings and tax relief. The employee determines that he or she is eligible to make a deductible, traditional IRA contribution, and therefore wants to recharacterize the previously made 2020 Roth IRA contribution.
Requirements to Recharacterize an IRA Contribution
Those federal employees or annuitants who want to recharacterize their 2020 IRA contributions must do all three of the following:
· Instruct the trustee of the IRA to which the original contributions were made (the “first” IRA) to transfer the contributions, as well as any income allocable to it, to the “second” IRA. If there was a loss, the net income transferred may be a negative amount.
· Report the recharacterization on their 2020 federal tax return (see below – “Reporting a Recharacterization – 2020”).
· Treat the contribution as having been made to the “second” IRA on the date that it was actually made to the “first” IRA.
Note that in order to initiate the recharacterization process, IRA owners must notify both the trustee (custodian) of the “first” IRA (the one to which the contribution was originally made) and the trustee (custodian) of the “second” IRA (the one to which the contribution is being moved) that they have elected to treat the contribution as having been made to the second IRA rather than the first. The notifications must be made by the date of the transfer the contributions and income/loss allocable to the contributions. Note that only one notification is required if both IRAs are maintained by the same trustee (custodian).
Reporting a Recharacterization
Individuals who elect to recharacterize a 2020 IRA contribution to one kind of IRA (Roth or traditional) as a contribution to another type of IRA must report the recharacterization on their 2020 federal income tax return, as directed by IRS Form 8606. When an individual recharacterizes an IRA contribution, the contribution is treated on the individual’s tax return as having been made to the second IRA. In addition, a statement that explains the recharacterization mut be attached to the return for the year in which the original contribution was made.
In addition, when an individual recharacterizes an IRA contribution, the trustee (custodian) of the “first” IRA must report the amount contributed before the recharacterization as a contribution. This contribution report is made by the IRA trustee (custodian) on IRS Form 5498 and the recharacterization is reported as a distribution on IRS Form 1099-R. A 2020 Form 1099-R reporting the recharacterization as a distribution should show the following codes in Box 7:
· Code N if the contribution and recharacterization both occurred in the year 2020
· Code R if the contribution was made for 2019 but not recharacterized until the year 2020
The trustee (custodian) of the “second” IRA is required to issue a Form 5498 reporting the amount received (the fair market value) via the direct “trustee-to-trustee” transfer in Box 4 of Form 5498.
The following two examples illustrate the process of recharacterization of an IRA. The first example is a traditional IRA contribution recharacterized as a Roth IRA contribution, and the second example is a Roth IRA contribution recharacterized as a traditional IRA contribution.
Traditional IRA Contribution is Recharacterized
Example 1. Ellen is a federal employee, single, and covered by the Federal Employees Retirement System (FERS). Ellen contributed $6,000 to a deductible traditional IRA on July 24, 2020. On January 21, 2021, she determines that her 2020 MAGI will limit her traditional IRA contribution deduction to $3,000. She decides to recharacterize $3,000 of the traditional contribution as a Roth IRA contribution. To do this, she has $3,300 ($3,000 contribution plus $300 related earnings) transferred from her traditional IRA to a Roth IRA in a direct trustee-to-trustee transfer. She intends to deduct the $3,000 traditional IRA contribution on her 2020 Form 1040.
Ellen is not required to file Form 8606, but she must attach a statement to her return that indicates: (1) She contributed $6,000 to a traditional IRA on July 24, 2020; (2) she recharacterized $3,000 of that contribution on January 21, 2021 by transferring $3,000 plus $300 of related earnings from her traditional IRA to a Roth IRA in a trustee-to-trustee transfer; (3) the entire $3,000 of the remaining traditional IRA contribution is deducted on Form 1040 (as ab adjustment to income).
Roth IRA Contribution is Recharacterized
If an individual contributes to a Roth IRA and later recharacterizes some or all of the contributions as a traditional IRA contribution, the individual needs to report the nondeductible portion of the traditional IRA contributions on Form 8606, Part I. If the entire contribution is not recharacterized, the individual should not report the portion of the contribution remaining in the Roth IRA on Form 8606. The individual should attach a statement to the return explaining the recharacterization. The following example illustrates:
Kent is a single federal employee. He contributed $5,000 to a Roth IRA on June 15, 2020. On January 15, 2021, Kent determined that his 2020 MAGI will allow him to fully deduct a traditional IRA contribution. He decides to recharacterize the Roth IRA contribution as a traditional IRA contribution. He has the $5,400 Roth IRA balance ($5,000 contribution plus $400 accrued earnings) transferred from his Roth IRA to a traditional IRA in a direct trustee-to-trustee transfer on January 15, 2021. Kent will deduct the $5,000 IRA contribution on his 2020 federal income tax return as an adjustment to income. Kent does not have to file Form 8606 but must attach a statement to his 2020 tax return that indicates that: (1) He contributed $5,000 to a Roth IRA on June 15, 2020; (2) he recharacterized the contribution on Jan. 15, 2021 by transferring the full $5,400 Roth IRA balance to a traditional IRA in a direct trustee-to-trustee transfer; and (3) $5,000 of the traditional IRA contribution is deducted on his 2020 federal income tax return.
The following table summarizes the reporting procedures in an IRA recharacterization for the year 2020:
Reporting A Recharacterization – 2020