3664 / Can an individual correct a Roth conversion? What is a recharacterization?

Editor’s Note: The 2017 tax reform legislation eliminated the ability of taxpayers to recharacterize Roth IRA conversions for tax years beginning after 2017. The IRS released a FAQ confirming that taxpayers were entitled to recharacterize 2017 conversions through October 15, 2018.

Prior to 2018, if a taxpayer rolled over funds from a traditional IRA or other eligible retirement plan to a Roth IRA during the taxable year, and later discovered that for any reason he or she wanted the transaction undone, the taxpayer generally had until the due date for filing his or her return (including extensions) to correct the conversion without penalty, to the extent all earnings and income allocable to the conversion were also transferred back to the original IRA, and no deduction had been allowed with respect to the original conversion.¹ This “recharacterization” in the form of a trustee-to-trustee transfer resulted in the recharacterized contribution being treated as a contribution made to the transferee IRA, instead of to the transferor IRA.² A taxpayer was able to apply to the IRS for relief from the time limit for making a recharacterization.³

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Planning Point: After tax reform, if a taxpayer makes a Roth contribution, he or she is permitted to recharacterize the transaction as a contribution to a traditional IRA before the due date for his or her income tax return for the year.⁴

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For purposes of a recharacterized contribution, the net income attributable to a contribution made to an IRA was determined by allocating to the contribution a pro-rata portion of the earnings or losses accrued by the IRA during the period the IRA held the contribution. This allowed the taxpayer to claim any net income that is a negative amount.⁵

A time restriction was placed on reconversions (i.e., converting to a Roth IRA a second time after recharacterizing a first conversion). A person could reconvert back to a Roth IRA but only after the later of the beginning of the next year or 30 days after the recharacterization.⁶

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Planning Point: Prior to 2018, where the value of converted property dropped after a conversion to a Roth IRA, it was often useful to recharacterize the contribution back to a traditional IRA and then reconvert to a Roth IRA to reduce the amount taxable on converting to a Roth IRA. The time restriction on reconversions reduced, but did not eliminate, the potential value of this technique.

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Reconversions and recharacterizations had to be reported to the IRS on Form 1099-R and Form 5498. Prior year recharacterizations had to be reported under separate codes. All recharacterized contributions received by an IRA in the same year were permitted to be totaled and reported on a single Form 5498.⁷