The IRA conversion and IRA recharacterizing rules can be easily confused. Following are the differences between these two IRA transactions.
What is a conversion?
A conversion occurs when IRA funds including assets (e.g., real estate, IRA owned LLC, notes, and even equities) are moved from a Traditional IRA, SIMPLE IRA, and SEP IRA to a Roth IRA. The IRA participant has the option to convert the IRA funds (assets and cash) directly or indirectly to the Roth IRA.
If done directly: the IRA custodian moves the funds and or assets directly to the Roth IRA.
If done indirectly: the IRA custodian distributes the funds and/or assets directly to the IRA participant resulting in the funds being deposited into the participant’s personal bank account and the assets get assigned in the participants personal name as well. The IRA participant then has 60 days to convert the funds and/or assets to the Roth IRA. This is the least favorable way to process a Roth IRA conversion because of the increased steps and deadline restriction.
More IRA Conversion Tidbits
- Conversions are not reversible. Once you convert the IRA to a Roth IRA, you cannot change your mind.
- The IRA conversion must be completed by December 31 of each year to complete a conversion for that year.
- The IRA participant can convert an unlimited amount of IRA, SIMPLE IRA, or SEP IRA funds to a Roth IRA.
What is a recharacterization?
A recharacterization occurs when the IRA participant makes an annual, regular contribution to one type of IRA and later treats it as made to another type of IRA. A regular contribution is the annual contribution you are allowed to make to a traditional or Roth IRA. For example, the IRA participant makes a Roth IRA contribution and later changes her mind and applies it as a Traditional IRA contribution. Lastly, a recharacterization does not include a conversion or any other rollover.
Recharacterizations Are Reversible
IRA recharacterizations are reversible during a year. For example, an IRA owner can recharacterize a Traditional IRA contribution as a Roth IRA contribution in January, and then decide to recharacterize the same contribution again in March. To recharacterize a regular IRA contribution, you tell the trustee of the financial institution holding your IRA to transfer the amount of the contribution plus earnings to a different type of IRA (either a Roth or traditional) in a trustee-to-trustee transfer or to a different type of IRA with the same trustee. If this is done by the due date for filing your tax return (including extensions), you can treat the contribution as made to the second IRA for that year (effectively ignoring the contribution to the first IRA).
Recharacterizations are Subject to the Annual IRA Contribution Limit
The maximum IRA amount that can recharacterized is the annual IRA contribution limit. If recharacterizing a 2020 Traditional or Roth IRA contribution, an IRA participant may recharacterize up to $6,000 ($7,000 if eligible for a catch-up contribution).
Recharacterizations can be Processed for the Prior Year
IRA participants have until October 15, 2021, to recharacterize a 2020 contribution, if they file their 2020 tax return timely.
IRA Conversion Vs. Recharacterization Chart