Benefits of Recharacterizing Individual Retirement Account Distributions

Image attribution: SaraJennMarketing, CC by S.A. 3.0

 Recharacterizing an Individual Retirement Account contribution is a financial mechanism that enables account owners to transfer money deposited into one IRA to anther type of IRA. The reasons for recharacterizations vary, but if done for good reasons recharacterizing of IRA contributions can outweigh the drawbacks allowing for several possible advantages in terms of financial and tax planning.

• Avoids withdrawal penalty

If done properly, an IRA recharacterization will be performed by the account trustee via a direct transfer of funds per Internal Revenue Service Publication 590. Since direct transfers don't involve the account owner receiving the money it can't be considered income by the IRS. This method of moving money between retirement accounts is advantageous because it avoids tax penalties associated with indirect withdrawals i.e. via the account owner.

• Reverses a conversion

IRA recharacterizations can also be used to reverse a conversion. A conversion occurs when funds in one type of IRA are rolled over to another type. The IRS does not allow a conversion and recharacterization in the same year, however a recharacterization of a previous tax year's conversion is possible. An important advantage of reversing a conversion to a traditional IRA is after tax contributions may grow tax free if it is recharacterized to a Roth IRA; this is because traditional IRA earnings are only tax deferred. 

• Extended recharacterization

So long as an original IRA contribution was made before the April tax filing deadline, and a tax filing was made on time, recharacterizations can take place up until October of the following tax year according to the IRS. The advantage of this is the six months of extra time may be beneficial when making financial decisions where more time is needed to assess the value of that decision.

 • Lower Adjustable Gross Income

Section 1.408A-5 of Title 26 of the U.S. Code states IRA's to which contributions have been recharacterized to can be treated as the basis of contribution for tax purposes. For example, recharacterization can be beneficial to the tax payer if recharacterizing from an after tax Roth to a tax deferred traditional IRA. Moreover, if the tax filer has income taxable at 25 percent but can lower this to 15 percent by recharacterizing after tax contributions to tax deferred contributions via recharcterization to a traditional IRA, then the recharacterization may be advantageous.



• Reallocates retirement funds

Another advantage of recharacterizing IRA contributions is it provides an opportunity to correct erroneous financial planning decisions. For example, a $2000 was deposited into a traditional IRA, but later the account owner realized it would be more beneficial from a financial planning perspective to have made the deposit into a Roth IRA. By recharacterizing the $2000 as a Roth IRA deposit the account owner is in effect reallocating the IRA contribution.

The process of re-characterization can become rather complicated by direct transfers between accounts, the filing of additional IRS forms and the back calculating of earnings or losses incurred within an IRA during the period prior to re-characterization. If however, the benefits of recharacterizing are worth the additional time and/or money spent performing the recharacterization, it may be a good idea to recharacterize IRA contributions. In any case, it may be a good idea to first consult with the IRS or a qualified tax planner before deciding to recharacterize IRA contributions to make sure it is the right financial decision.