When it comes to IRAs, the terms "conversion" and "recharacterization" refer to opposite actions -- respectively, converting a traditional IRA to a Roth IRA and vice versa. Each has its own set of rules and tax implications. Here's what you need to know.
Converting an IRA
An IRA conversion, also known as a rollover, generally refers to the act of transferring assets held in a traditional IRA, or a similar retirement account, to a Roth IRA. Most investors can convert their IRA to a Roth, even if they earn too much money to contribute to a Roth IRA directly. A Roth conversion is possible for these account types:
- Traditional IRA
- Rollover IRA
- SIMPLE IRA
- SARSEP IRA
- 401(k) from a former employer
- 403(b) from a former employer
- Governmental 457(b) from a former employer
The biggest drawback you need to consider is that a Roth conversion is a taxable event, which means that any assets you convert to a Roth account will be included in your gross income. So, if you have a large traditional IRA, it may be wise to do the conversion over several years to avoid getting hit with a huge tax bill.
There are several perks to a Roth conversion. First, Roth accounts have no required minimum distributions, whereas the accounts listed above require you to start making withdrawals once you reach age 70 1/2. However, keep in mind that if you're due for an RMD in the year you're converting, you still need to take it.
A Roth IRA also lets you "lock in" your current tax bracket: You pay taxes up front at your current income tax rate, and your qualified withdrawals in retirement are tax-free. If you have reason to believe that you'll be in a higher tax bracket when you retire, then a conversion may be right for you. Plus, who knows what the federal income tax brackets will look like when you retire? The current top tax rate of 39.6% may sound high, but it has been much higher at certain times in the past, and could easily climb again.
Recharacterization of an IRA conversion
Recharacterizing an IRA basically means undoing an IRA conversion and putting the funds back into a traditional IRA. A common reason people recharacterize their Roth rollovers is that they're taken by surprise by the tax burden that accompanies a Roth conversion.
As long as you recharacterize your Roth IRA conversion by the extended tax deadline (Oct. 15), you can treat it as a traditional IRA contribution for tax purposes -- so you won't have to pay tax on the conversion. For example, if you converted your traditional IRA to a Roth IRA in 2015, then you have until Oct. 15, 2016 to recharacterize the conversion back to a traditional IRA to avoid paying taxes. If you file your tax return before you recharacterize, you can submit an amended tax return to remedy the situation.
One final rule: If you recharacterize your conversion, you have to wait until the later of 30 days or the following calendar year before you reconvert to a Roth.
The bottom line on IRA conversions and recharacterizations
While it's definitely nice to have a "do over" option after you convert your retirement account to a Roth, the best approach is to understand the tax implications before you roll those funds over -- after all, the last thing you want to do is forget to recharacterize your conversion in the appropriate time frame and face a massive tax bill you're unprepared for.
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