Clearing Up Common Misconceptions About Two Commonly Misunderstood IRA Transactions
By Jennifer Bassett, QKA, CISP, CIP, CHSP
Conversions and recharacterizations—do you know everything there is to know about these transactions? If not, that’s ok. You’re not alone. Although conversions and recharacterizations are fairly common, many who work with IRAs don’t fully understand how they work. Here we’ll clear up some common misconceptions about these two types of transactions.
Basic Overview
Before we start comparing conversions and recharacterizations, let’s go over the basics. A conversion is the movement of assets from a Traditional IRA, including any simplified employee pension (SEP) plan assets, or SIMPLE IRA to a Roth IRA. IRA owners can directly or indirectly convert assets to a Roth IRA. A direct conversion is when Traditional or SIMPLE IRA assets move directly to a Roth IRA: the IRA owner does not receive the assets. An indirect conversion is when the IRA owner receives a Traditional or SIMPLE IRA distribution and then has 60 days to convert the assets to a Roth IRA.
A recharacterization is how an IRA owner can “undo” regular IRA contributions or treat them as though they were made to a different type of IRA. For example, an IRA owner may recharacterize a regular Roth IRA contribution as a Traditional IRA contribution.
Now that we have a general understanding of what conversions and recharacterizations are, let’s answer some of the more common questions surrounding these transactions.
Which Transaction Is Reversible?
Because IRA owners can complete an unlimited number of recharacterizations during a year, you might consider a recharacterization to be “reversible.” For example, an IRA owner can recharacterize a Traditional IRA contribution as a Roth IRA contribution in February, and then decide to recharacterize the same contribution again in March. Conversions, however, are irreversible. Once an IRA owner converts assets to a Roth IRA, the transaction cannot be undone.
Which Transaction Is Taxable?
A conversion generally is a taxable transaction: IRA owners must include any pretax assets that they convert in their taxable income for the year of the conversion. Although after-tax Traditional IRA assets are not taxed when converted to a Roth IRA, IRA owners cannot convert just their after-tax assets. Any assets converted to a Roth IRA are treated as pro rata portions of after-tax and pretax assets. For example, if 80 percent of an individual’s total IRA assets consist of pretax assets, and 20 percent after-tax assets, the conversion—regardless of the amount—will be 80 percent taxable and 20 percent nontaxable. IRA owners should seek competent tax advice for questions regarding the taxation of their conversions.
Which Transaction Can Be Done for the Prior Year?
Individuals who file their tax return on time generally have a six-month extension (until October 15) to recharacterize a contribution. For example, IRA owners have until October 15, 2021, to recharacterize a 2020 contribution, if they file their 2020 tax return timely.
There are no prior-year conversions. IRA owners have until December 31 of each year to complete a conversion for that year.
Which Transaction Is Limited to a Certain Dollar Amount?
IRA owners may recharacterize a regular contribution amount that does not exceed the annual contribution limit. If recharacterizing a 2020 Traditional or Roth IRA contribution, an IRA owner may recharacterize up to $6,000 ($7,000 if eligible for a catch-up contribution).
There is no dollar limit for conversions. IRA owners may convert their entire Traditional or SIMPLE IRA balance to a Roth IRA.
Which Transaction Is Reportable?
Both conversions and recharacterizations are reportable transactions. Financial organizations must report these transactions on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., and Form 5498, IRA Contribution Information.
Know the Basics
Have we taken some of the mystery out of conversions and recharacterizations for you? While you don’t need to know every detail about these transactions, you should understand the basic rules. Your clients will expect it. Following is a brief summary.
