IRA Do-Over: Reversing Contributions and Conversions

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IRA Do-Over: Reversing Contributions and Conversions
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
October 7, 2009

Key points

You can reverse an IRA contribution or conversion with a recharacterization.
When it might make sense to recharacterize a Roth conversion, then reconvert for tax savings.
Useful information for anyone with an IRA.

Everyone makes a mistake now and then. That's OK, as long as we manage to learn and grow from it. Still, wouldn't it be nice if just once in a while we were allowed a do-over?

That's exactly what we get when it comes to IRA contributions and conversions we wish we never made. In this case, the unlikely source of forgiveness—the IRS—calls it a recharacterization.

What is a recharacterization?
A recharacterization allows you to reverse an IRA contribution or conversion under a variety of circumstances.

For example:

Contributions. Maybe you contributed to a traditional IRA but later decide you want to switch it to a Roth. Or you contributed to a Roth IRA early in the year but later earned too much to qualify. Or your income turned out to be lower than you thought, and you want to switch to a traditional IRA because you can now deduct the contribution after all.

The reason doesn't matter. The recharacterization rules allow you to reverse the transaction—though you must also recharacterize any earnings on your contribution.
Roth conversions. Maybe you converted all or part of a traditional IRA to a Roth IRA, but the market fell dramatically after your conversion, and you want to reverse the transaction to reconvert at a lower balance to reduce your tax bill. Again, the reason doesn't matter and no explanations are necessary.

Seeing if you qualify
There are some rules and requirements to qualify for a recharacterization, and the details can get complex, especially when a partial recharacterization is involved. You'll want to check out the recharacterization instructions on IRS Form 8606 and consult your tax professional.

That said, here are some basics to keep in mind:

You can recharacterize a contribution or conversion any time up to the income tax filing deadline, plus extension, for the tax year of the conversion. For example, if you convert in the 2010 tax year, you can recharacterize as late as October 15, 2011.¹
If you converted from a traditional IRA to a Roth IRA, and later recharacterize that conversion, you can't reconvert back to a Roth until the calendar year following your original conversion (2011 or later if you converted in 2010, for instance) and you must wait at least 31 days after the recharacterization.

By way of example, say you converted a balance of $50,000 from a traditional IRA to a Roth IRA and the entire amount was taxed at a combined marginal rate of 30%—a $15,000 tax bill. Subsequently, the market drops and the converted balance falls to $40,000. If you recharacterize the transaction—placing the money back in a traditional IRA—and then reconvert the $40,000 to a Roth IRA, you will owe $12,000 in taxes instead of $15,000—a savings of $3,000.

Keep in mind that you'll have to satisfy the waiting period—during which time the market could rise.

Get help if you need it
In addition to reviewing the instructions for IRS Form 8606, you should also read the section on recharacterization in IRS Publication 590. And again, talk to your tax advisor regarding your particular situation.

Finally, see the Take action box at top right for ways Schwab can help with your IRA set-up, Roth conversions and, if needed, recharacterizations.

1. Though you would need to file an amended federal and state income tax return in the event you didn't request an extension and filed your 2010 return by the normal due date of April 15, 2011.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized advice.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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