Can a client recharacterize a Roth IRA contribution to an IRA contribution?
Question of the week: Can a Roth IRA contribution be recharacterized as a deductible IRA contribution? How would taxpayers account for a loss?
Q. Can a client recharacterize a Roth IRA contribution to a traditional IRA? What if the Roth went down in value?
In January my client made a $5,000 Roth IRA contribution. He has been making regular Roth contributions for several years. He’s in a 401(k) plan at work and earns too much to make a deductible IRA contribution. This year, his hours and earnings have been reduced because of the coronavirus and he could very well end up below the earnings cutoff to make a fully deductible IRA contribution after all, which he would prefer. Can my client recharacterize his Roth IRA contribution if his earnings are low enough to permit a deductible IRA? What happens if the Roth IRA has lost money?
A. Your client can recharacterize the Roth IRA contribution less the allocated loss by the due date of the return.
The TCJA eliminated the ability to recharacterize conversion contributions to a Roth, but not original contributions. The recharacterization must be made in a trustee-to-trustee transfer by the due date of the 2020 tax return, including extensions.
The amount recharacterized would usually include earnings. However, if the Roth IRA has declined in value, the amount transferred would instead take the loss into consideration. The earnings, or loss attributed to the Roth contribution is figured in the same way:
Net Income (loss) = Contribution × (Adjusted Closing Balance - Adjusted Opening Balance) / Adjusted Opening Balance.
Here, the opening balance is the balance in the account immediately before the Roth contribution and the closing balance is the balance right before the transfer.
Suppose the balance in your client’s Roth IRA is $50,000 right before he made the Roth contribution and $40,000 when he decides to make the transfer. The loss would be -$1,000 [$5,000 × ($40,000 - $50,000)/$50,000]. The amount your client would transfer to the traditional IRA would therefore be $4,000 ($5,000 - $1,000).
Note that your client would still be able to take a $5,000 IRA deduction despite the loss in value. In other words, by making the transfer, it is as if the $5,000 contribution had been made to the traditional IRA to begin with, regardless of whether the IRA gained or lost value after the contribution.
In most cases, the net amount to be transferred is determined by the IRS trustee or custodian. That is, the trustee should compute the adjusted closing balance and adjusted opening balance to arrive at the net income (loss) for recharacterization purposes.
Rather than making the transfer right away, your client may want to wait to see where his income actually is for the year. He could wind up in the phaseout range so that a recharacterization would result in only a partially deductible IRA.
For more information on Roth IRA, see the Insights article Early distribution from Roth after conversion
Originally published in the April 15, 2020 edition of TAX in the News.