Edward A. Zurndorfer
Previous FEDZONE columns this month explained that federal employees and, if they are married, their spouses, have until April 15, 2020, to make their 2019 individual retirement arrangement (IRA) contributions. There are two types of IRAs that employees can contribute to; namely, a traditional IRA (either “deductible” or “nondeductible”) or a Roth IRA. Both types of IRAs were discussed in the two previous FEDZONE columns in January.
Many federal employees have already made their 2019 IRA contributions. In the previous January 2020 FEDZONE columns discussing the traditional IRA and Roth IRA, the specific requirements for making traditional IRA and Roth IRA contributions were detailed. Unfortunately, some individuals made their 2019 contributions to the wrong type of IRA. This column discusses how an individual can “recharacterize” an IRA contribution if the individual discovers that a contribution was made to the wrong type of IRA.
Contributions to one type of IRA can be treated as having been contributed to a different type of IRA. For example, contributions to a Roth IRA can be made and treated as contributions to a traditional IRA. This is called recharacterizing the contribution.
Why would an individual want to recharacterize an IRA contribution? One possibility would be the example of an individual who, during calendar year 2019 made a Roth IRA contribution and now in January 2020 has received all of his or her 2019 income information via W-2’s and 1099’s. The individual has determined that his or her 2019 modified adjusted gross income (MAGI) was over the allowable limit for making a 2019 Roth IRA contribution. A previous FEDZONE column discussed the MAGI limits for making Roth IRA contributions. The individual now realizes that he or she exceeded the MAGI limit and is eligible to recharacterize the contribution as a nondeductible traditional IRA contribution. If the recharacterization is performed in the proper way and before the individual files his or her 2019 federal income tax return, there will be no tax consequences and no penalties.
Here are two examples that illustrate the recharacterization process:
Example 1. (Traditional IRA contribution is recharacterized). Judy is a federal employee covered by FERS, and contributes to the Thrift Savings Plan (TSP). She contributed $5,000 to a new deductible traditional IRA on Sept. 26, 2019. On Jan. 19, 2020, Judy’s traditional IRA is worth $5,500. She decides to recharacterize $4,000 of the traditional IRA contribution as a Roth IRA contribution. To accomplish this, Judy has $4,400 ($4,000 contribution plus $400 related earnings) transferred from her traditional IRA to a Roth IRA via a trustee-to-trustee transfer. Judy deducts the $1,000 traditional IRA contribution on her 2019 Form 1040. She is not required to file IRS Form 8606 (Nondeductible IRAs), but she must attach a statement to her 2019 federal tax return that indicates the following:
- She contributed $5,000 to a traditional IRA on Sept. 26, 2019;
- She recharacterized $4,000 of that contribution on Jan. 19, 2020 by transferring $4,000 plus $400 of related earnings from her traditional IRA to a Roth IRA in a trustee-to-trustee transfer.
- The entire $1,000 of the remaining IRA contribution is deducted (as an adjustment to income) on her 2019 Form 1040.
Judy does not report the $4,400 distribution from her traditional IRA on her 2019 Form 1040 because the distribution occurred in 2020. She does not report the distribution on her 2020 Form 1040 because the recharacterization was related to 2019 and was explained in an attachment to her 2019 tax return.
Example 2. (Roth IRA contribution is recharacterized). Kevin is a federal employee. He contributed $4,000 to a new Roth IRA on June 15, 2019. On Jan. 21, 2020, Kevin determined that his 2019 modified adjusted gross income (MAGI) will allow him to fully deduct a traditional IRA contribution. He decides to recharacterize the Roth IRA contribution as a traditional IRA contribution. He has the $4,200 Roth IRA balance ($4,000 contribution plus $200 accrued earnings) transferred from his Roth IRA to a traditional IRA in a trustee-to-trustee transfer on Jan. 21, 2020. Kevin then deducts (as an adjustment to income) the $4,000 traditional IRA contribution on his 2019 federal income tax return. He is not required to file Form 8606 (Nondeductible IRAs), but must attach a statement to his 2019 federal income tax return that indicates that:
- He contributed $4,000 to a new Roth IRA on June 15, 2019.
- He recharacterized the contribution on Jan. 21, 2020 by transferring $4,200, the balance in the Roth IRA, to a traditional IRA in a trustee-to-trustee transfer.
- $4,000 of the traditional IRA contribution is deducted (as an adjustment to income) on his 2019 federal income tax return.
He includes the $4,200 distribution from the Roth IRA on the line for “IRA distributions” on his 2019 federal income tax return.
How to Recharacterize an IRA Contribution
To recharacterize an IRA contribution, the contribution must be transferred from the first IRA (the one to which the contribution was made) to the second IRA in a direct trustee-to-trustee transfer. The deadline for the transfer is the due date (including extensions) for the tax return for the year for which the contribution to the first IRA was made. This means that any individual who wants to recharacterize an IRA contribution made for the year 2019 has until October 15, 2020 (the extension deadline for filing 2019 income tax returns).
Individuals who recharacterize their IRA contributions (from a nondeductible traditional IRA contribution to a Roth IRA, or from a Roth IRA to a nondeductible traditional IRA contribution) must do all of the following:
● Instruct the first IRA trustee to directly transfer the contribution, as well as any net income allocable to it, to the second IRA. If there was a loss, the net income transferred may be a negative amount (in most cases, the net income allocable to the transfer is determined by the IRA trustee or custodian).
● Report the recharacterization on Form 8606 of their federal tax return for the year during which the contribution was made (see below).
● Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.
Reporting a Recharacterization
Individuals who elect to recharacterize a 2019 IRA contribution to one kind of IRA (Roth or non-Roth) as a contribution to another type of IRA must report the recharacterization on their 2019 federal income tax return as directed by IRS Form 8606 and its instructions. To the extent a contribution is recharacterized, it is treated on the tax return as having been made to the second IRA. In addition, a statement that explains the recharacterization must be attached to the 2019 federal income tax return.
When an individual recharacterizes an IRA contribution, the IRA trustee of the first IRA (the IRA to which the contribution originally was made) must report the amount contributed before the recharacterization as recharacterized contributions on Form 5498 Box 4 (IRA Contribution Information) (2020 version) and the recharacterization as a distribution on 2019 Form 1099-R (Distributions from Pensions, Annuities, Insurance Contracts). A 2019 Form 1099-R reporting the recharacterized amount as a distribution should show the following codes in Box 7:
● Code N if the contribution and recharacterization both occurred in 2019
● Code R if the contribution was made for 2018, but recharacterized in 2019
The trustee of the second IRA is required to issue a Form 5498 for 2020 reporting the fair market value of the IRA received on Form 5498 in Box 4.
The following table summarizes the reporting of a recharacterization of an IRA contribution:
Reporting a Recharacterization
|Initial Contribution||Re-characterization||Report on IRS Form 8606||Recharacterization & Contribution in the Same Year|
|to nondeductible traditional IRA||Transfer to Roth IRA||Only the part, if any, of the contribution that is not recharacterized (the amount left in the traditional IRA) to the extent it is nondeductible.||Amount transferred from the traditional IRA to the Roth IRA|
|to Roth IRA||Transfer to nondeductible traditional IRA||Only the part, if any, of the contribution that is recharacterized to the traditional IRA, to the extent it is nondeductible||Amount transferred from the Roth IRA to the traditional IRA|
Finally, under the Tax Cuts and Jobs Act of 2017 (TCJA), effective Jan. 1, 2018, a conversion from an existing traditional IRA, a SEP IRA, or a SIMPLE IRA to a Roth IRA cannot be recharacterized. TCJA also prohibits recharacterizing amounts rolled over to a Roth IRA from other retirement plans, such as the traditional TSP, 401(k) or 403(b) retirement plans. Therefore, with the passage of TCJA, a recharacterization can only be performed to recharacterize contributions made to traditional IRAs and Roth IRA contributions, as discussed and illustrated above.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
Recharacterizing 2019 IRA Contributions