An individual retirement account (IRA) recharacterization is a procedure for reversing an IRA conversion or contribution in the event it creates a financial disadvantage for the holder of the account. It may become necessary to do this for tax or income eligibility reasons. Taxpayers should be very careful with an IRA recharacterization because the process is complicated, and it is possible to make errors that may result in a larger tax bill or other problems. It may be necessary to consult a financial professional.
In the case of an IRA conversion, sometimes taxpayers convert their IRAs from traditional to Roth or other formats, and later realize this puts them at a disadvantage. They can request an IRA characterization to roll back the decision, restoring the account to a traditional format. To do this, it is necessary to open a new traditional IRA and transfer the funds, taking note of any profits and losses on the account to make it possible to declare them on taxes. Investors can also recharacterize in the other direction, turning a traditional into a Roth.
IRA contributions sometimes end up exceeding limits or income eligibility, especially for investors with fluctuating income who end up underestimating how much money they earn in a given year. These investors can use an IRA recharacterization to undo these contributions. It is not possible, however, to reverse employer contributions under the rules pertaining to IRA recharacterization procedures.
Before embarking on an IRA recharacterization, it is important to meet with a financial adviser or accountant to get some advice. The recharacterization needs to take place within a specific time frame, and there are some steps the investor must follow to do it properly. It is also important to make sure the documentation for the account is accurate and complete to avoid problems with tax returns. A misstatement on a tax return made in innocence can be corrected with an amended tax return, but the IRS may view the investor with increased suspicion in the future.
Financial planners can provide assistance with setting up retirement accounts and making any necessary changes to meet investment needs. Investors should be aware that they may incur penalties with activities like IRA recharacterization, and they might also have to make some adjustments on their taxes. They should make sure the decision is right for the given situation. An accountant may be able to provide some assistance and information about options so the investor can make an informed decision about how to protect retirement accounts and other investments.