Retirement Plan Recharacterization - John R. Dundon II, Enrolled Agent
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Retirement Plan Recharacterization

Retirement Plan Recharacterization

Retirement Plan Recharacterization means according to Reg. Sec. 1.408A-5 that if you make a contribution to one type of IRA you may be able to treat the contribution as though it had been made to a different type of IRA. This is basically considered a correction if you will which can be significant for a wide variety of reasons.

One common reason that I’ve seen is if you converted a traditional IRA to a Roth IRA you may want to recharacterize the Roth IRA back to a traditional IRA if the value of the assets in the Roth IRA has declined between the conversion date and the due date for the tax return reporting the conversion.

This is because the amount you would have to include in income as a result of the conversion to a Roth IRA is based on the value of the account at the time of the conversion and does not take into account the decline in value between the conversion date and the due date of the return including extensions.

However a most common issue for recharacterization purposes occurs when you receive a distribution from a traditional IRA in one tax year and roll it over into a ROTH IRA in the next tax year but still within 60 days of the distribution from the traditional IRA. In this case you treat the contribution to the ROTH IRA as though it occurred in the year of the distribution from the traditional IRA.

You recharacterize a contribution or IRA conversion in either of two ways, a trustee-to-trustee transfer or simply by re-designating the first IRA as the second IRA, rather than transferring the account balance.

If you elect to recharacterize an IRA contribution you must report the recharacterization, and you must treat the contribution as having been made to the second IRA instead of the first IRA, on your income tax return for the tax year for which the recharacterized contribution was made to the first IRA. There are 2 types of recharacterizations that I’ll address.

1. You made a contribution to a traditional IRA and later recharacterized part or all of it to a Roth IRA.

If you recharacterizes only part of the contribution and the contribution included nondeductible amounts, you must report any nondeductible portion that remains in the traditional IRA on Part I of Form 8606, Nondeductible IRAs. If you recharacterize the entire contribution you do not report the contribution on Form 8606. See IRS Form 8606 Instructions for further information.

In either case, you must attach a statement to your tax return explaining the recharacterization.

For example if you contributed $4,000 to a new traditional IRA on May 27, 2013 and on February 24, 2014, you determined according to the active participant rules that your 2013 modified adjusted gross income will limit your traditional IRA deduction to $1,000. The value of your traditional IRA by that time grew to $4,400. You decided to recharacterize $3,000 of the traditional IRA contribution as a Roth IRA contribution, and have $3,300 ($3,000 contribution plus $300 related earnings) transferred from your traditional IRA to a Roth IRA in a trustee-to-trustee transfer and subsequently deduct the $1,000 traditional IRA contribution on Form 1040.

In this case you do not have to file Form 8606, but must attach a statement to your return explaining the recharacterization.

The statement indicates that you:

(a) contributed $4,000 to a traditional IRA on May 27, 2013;

(b) recharacterized $3,000 of that contribution on February 24, 2014, by transferring $3,000 plus $300 of related earnings from the traditional IRA to a Roth IRA in a trustee-to-trustee transfer; and

(c) that all $1,000 of the remaining traditional IRA contribution is deducted on Form 1040.

You do not report the $3,300 distribution from the traditional IRA on her 2013 Form 1040 because the distribution occurred in 2014. You do not report the distribution on your 2014 Form 1040 either, because the recharacterization related to 2013 and was explained in an attachment to her 2013 return.

2. You rolled over an amount from a qualified retirement plan to a Roth IRA in 2013 and later recharacterized all or part of the amount to a traditional IRA.

If you recharacterizes only part of the amount rolled over, you must report the amount not recharacterized on Form 8606, Nondeductible IRAs. If you recharacterizes the entire amount you do not report the recharacterization on Form 8606.

In either case, you must attach a statement to your tax return explaining the recharacterization and you must include the amount of the original rollover on the line for “pensions and annuities” on Form 1040, Form 1040A, or Form 1040NR. If the recharacterization occurred during the year for which the return is being filed, you must also include the amount transferred from the Roth IRA on the line for “IRA distributions” on Form 1040, Form 1040A, or Form 1040NR.

If the recharacterization occurred in the following year, you report the amount transferred only in the attached statement, and not on his or her return for the preceding year or for the year in which the recharacterization occurred.

For example you rolled over $50,000 from your 401(k) plan to a new Roth IRA on July 20, 2013. On March 25, 2014, you decided to recharacterize the rollover. The value of the Roth IRA on that date is $49,000. You recharacterize the rollover by transferring that entire amount to a traditional IRA in a trustee-to-trustee transfer and report $50,000 as an amount received from pensions and annuities on the line for “IRA distributions” on your 2013 Form 1040. You do not include the $49,000 as an IRA distribution on line 15a because it did not occur in 2013. You also do not report that amount on his 2014 return because it does not apply to the 2014 tax year. You do not have to file Form 8606, but you must attach a statement to his 2013 Form 1040 explaining that:

(a) you made a rollover of $50,000 from a Code Sec. 401(k) plan to a Roth IRA on July 20, 2013, and

(b) you recharacterized the entire amount, which was then valued at $49,000, to a traditional IRA on March 25, 2014.

Transfer of Allocable Earnings

One of the more difficult aspects of recharacterization for taxpayers to pick up on is the fact that if you recharacterizes a contribution or a Roth IRA conversion amount you must include in the transfer any earnings allocable to the contribution or conversion being recharacterized according to Reg. Sec. 1.408A-5.

If you recharacterize a contribution you must include in the transfer any earnings allocable to the contribution. If there was a loss, the amount transferred must be reduced by the amount of the loss. In most cases, the amount of the earnings that needs to be transferred is determined by the IRA trustee or custodian.

If you have a transfer agent as inept as Mass Mutual for example that lacks the professional acumen to calculate earnings on recharacterizations you may determine the amount of earnings allocable to an IRA contribution and the total amount to be recharacterized by following these steps:

Step 1: Determine the amount of the IRA contribution to be recharacterized.

Step 2: Determine the IRA’s adjusted closing balance which is the IRA’s fair market value at the end of the “computation period” plus the amount of any distributions, transfers, and recharacterizations made from the IRA during the computation period.

The computation period is the period beginning just before the time the particular contribution being recharacterized is made to the IRA and ending just before the recharacterizing transfer of the contribution.

Step 3: Determine the IRA’s adjusted opening balance.

The adjusted opening balance is the fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers (including the contribution that is being recharacterized under Code Sec. 408A(d)(6) and any other recharacterizations) made to the IRA during the computation period.

Step 4: Subtract the adjusted opening balance in Step 3 from the adjusted closing balance in Step 2.

Step 5: Divide the amount in Step 4 by the adjusted opening balance in Step 3, and enter the result as a decimal rounded to at least three places.

Step 6: Multiply the amount in Step 1 by the decimal determined in Step 5. This is the net income attributable to the contribution to be recharacterized.

Step 7: Add the amounts in Step 1 and Step 6. This is the amount of the IRA contribution, plus the net income attributable to it, to be recharacterized.

Lessons I’ve Learned

The following are some important lessons I’ve learned in defending (and preparing) tax returns for people who engaged this concept of recharacterization:

1. Generally, both the election to recharacterize and the transfer must take place on or before the due date for filing the tax return for the year for which the contribution or conversion was made to the first IRA.

2. To add even more salt to the water special procedures are available that allow someone who has already filed a timely tax return to recharacterize contributions for up to six months after his or her tax return’s due date exclusive of extensions.

3. If you elect to recharacterize an IRA contribution or Roth IRA conversion amount you must report the recharacterization, and must treat the contribution or conversion as having been made to the second IRA instead of the first IRA, on your income tax return for the tax year for which the recharacterized contribution was made to the first IRA

4. To recharacterize a contribution, you generally must have the contribution transferred from the first IRA to the second IRA in a trustee-to-trustee transfer. Generally, the transfer to the second IRA must be made by the due date of your tax return for the year during which the contribution to the first IRA was made.

5. Recharacterizations made with the same trustee can be made by re-designating the first IRA as the second IRA, rather than transferring the account balance.

6. After the transfer has taken place, the election to recharacterize is irrevocable. When you recharacterizes a contribution you must:

(a) include in the transfer any net income allocable to the contribution

(b) report the recharacterization on your tax return for the year during which the contribution was made; and

(c) treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.

7. You must also notify both the trustee of the first IRA and the trustee of the second IRA that you elected to treat the contribution as having been made to the second IRA rather than the first by the date of the transfer.

Only one notification is required if both IRAs are maintained by the same trustee and include:

(a) the type and amount of the contribution to the first IRA that is to be recharacterized;

(b) the date on which the contribution was made to the first IRA and the year for which it was made;

(c) a direction to the trustee of the first IRA to transfer in a trustee-to-trustee transfer the amount of the contribution and any net income (or loss) allocable to the contribution to the trustee of the second IRA;

(d) the name of the trustee of the first IRA and the name of the trustee of the second IRA; and

(e) any additional information needed to make the transfer.

8. 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.

9. Generally, any amount that has been moved from one IRA to another in a tax-free transfer, such as a rollover, cannot be recharacterized. However, a taxpayer who mistakenly rolls over or transfers an amount from a traditional IRA to a SIMPLE IRA can later recharacterize that amount as a contribution to another traditional IRA.

10. If you receive a distribution from traditional IRA and contribute the entire amount to a different traditional IRA in a rollover contribution you cannot elect to recharacterize the contribution by transferring the contribution amount, plus net income, to a Roth IRA, because an amount contributed to an IRA in a tax-free transfer cannot be recharacterized. However, you can convert (other than by recharacterization) the amount in the second traditional IRA to a Roth IRA at any time, provided it satisfies the requirements for a qualified rollover contribution.

11. Employer contributions including elective deferrals under a SEP or SIMPLE plan cannot be recharacterized as contributions to another IRA. However, an amount converted from a SEP IRA or SIMPLE IRA to a Roth IRA can be recharacterized to a SEP IRA or SIMPLE IRA, including the original SEP IRA or SIMPLE IRA.

12. You cannot deduct any loss that occurred while the funds were in the first IRA. Also, no deduction is allowed for a contribution to a traditional IRA if the amount is later recharacterized.

13. The recharacterization of a contribution is never treated as a rollover for purposes of the one-year waiting period even if the contribution would have been treated as a rollover contribution by the second IRA if it had been made directly to the second IRA rather than as a result of a recharacterization of a contribution to the first IRA.

14. Timing of recharacterization. Generally, both the election to recharacterize and the transfer must take place on or before the due date (including extensions) for filing the tax return for the year for which the contribution to be recharacterized was made. If you miss the election deadline you can still elect to recharacterize a contribution if:

(1) your tax return was timely filed for the year the election should have been made; and

(2) you take appropriate corrective action within six months from the due date of the return, not including extensions consisting of: notifying the trustee of the taxpayer’s intent to recharacterize; providing the trustee with all necessary information; and having the trustee transfer the contribution.

After taking the necessary corrective action, you must amend your tax return to show the recharacterization. In addition to reporting the recharacterization, you must write on the amended return, “Filed pursuant to section 301.9100-2

Excess contributions actually made for a prior year and deemed to be current-year contributions for purposes of the Code Sec. 4973 excise tax on excess contributions may be recharacterized only if recharacterization would still be timely with respect to the tax year for which the contributions were actually made. This rule applies to any excess contribution, whether made to a traditional or a Roth IRA.

For more information see IRS Publication 590 – Individual Retirement Arrangements.

 



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