Articles Moving Your Money: IRA Conversions & Recharacterizations

November 19, 2014

The words "conversion" and "recharacterization" may seem synonymous outside the realm of retirement planning. However, as they apply to your Individual Retirement Account (IRA), the words have a distinct difference that sets them apart, while still similar. Conversion refers to the transition of a Traditional IRA to a Roth IRA, and recharacterization refers to changing a Roth IRA back into a Traditional IRA. Both of these actions involve specific rules and tax implications.

Conversions

If you're a tax-savvy investor, you likely want to pay as little income tax as possible. Converting to a Roth IRA can be a smart tax move that will save money in the long run. If you anticipate your income dropping significantly in a certain year (and increasing in following years), then a conversion could be done in the low-income year. Since your income is lower, you may be in a lower tax bracket when you convert. Likewise, if the government-announced tax rate increases go into effect the following year, then a conversion in the current year might save you some taxes.

Converting to a Navy Federal Roth IRA will guarantee you'll owe no additional income tax on the converted funds during retirement. The balance in your portfolio will be what you can tap in retirement, and you won't have to calculate an after-tax balance.

Before converting your existing IRA into a Roth IRA, take time to speak with a competent tax advisor to understand all the potential taxes that could be due. Consider the following:

  • Years left until you retire
  • Years you'll spend retired
  • Potential resulting taxes
  • Anticipated rate of return

Identify any non-IRA funds you have at your disposal to cover any tax liabilities—that way the funds you convert can continue to grow tax-free. This is especially helpful for those under age 59½, as any IRA assets used to pay conversion taxes are subject to an IRS 10 percent early distribution tax.

When converting your IRA, you're required to report the amount of previously deducted contributions and dividends since they haven't been taxed. Conversions are reported as a distribution from the Traditional IRA and as a conversion to the Roth IRA. If you withdraw any of the assets you converted from a Traditional or Simplified Employee Pension (SEP) to a Roth within the first five years following your conversion, you may pay a 10 percent penalty on the amount withdrawn, regardless of age.

Recharacterization

Recharacterization allows you to "unconvert" a Roth IRA, returning it to a Traditional IRA without IRS penalties. (You may also recharacterize a conversion from an SEP and employer pension/profit-sharing plan.) Recharacterization follows the same process as a conversion; however, as with a rollover, you may only recharacterize assets once per calendar year.

Recharacterization may also include recharacterizing a contribution made during the current year. For example, if you made a contribution to a Traditional IRA and then discovered that the contribution was non-deductible, you may choose to recharacterize the contribution to a Roth IRA. This recharacterization must be done before the tax filing deadline, plus extensions.

Work with a professional to determine if either of these options fits your retirement savings needs.


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