Convert or Recharacterize—What’s the Difference For Your IRA?

If conversions and recharacterizations are foreign to you, don’t worry. We’re here to help you decipher IRS jargon and learn the differences between the two.

Convert or Recharacterize—What’s the Difference

When it comes to making changes to past Traditional or Roth IRA contributions, recharacterizing and converting seem like interchangeable concepts—but they actually have very different meanings. Confusing the two can result in unintended tax consequences, so we’ll help you understand the differences.

Please note, however, that Betterment is not a tax advisor, and we don’t provide tax advice as a service, so this information is just for educational purposes. You should consult a qualified tax professional regarding your personal situation.

We have more information on the differences between a Traditional IRA and a Roth IRA to help you decide which is right for you.

What exactly is a conversion?

A conversion is a one-way street. It’s a potentially taxable event where funds are transferred from a Traditional IRA to a Roth IRA. There is no such thing as a Roth to Traditional conversion.

There is no cap on the amount that’s eligible to be converted, so the sky’s the limit for those that choose to convert. If your Traditional IRA includes non-deductible contributions, part or all of the conversion may be non-taxable. If the Traditional is all pre-tax money, then the conversion is fully taxable.

Let’s say you want to fund a Roth IRA to take advantage of tax-free withdrawals in retirement, but your income is too high. For 2019, this would be the case if your income is over $137,000 if you file as single, or over $203,000 if you file as married filing jointly. For 2020, this would be the case if your income is over $139,000 if you file as single, or over $206,000 if you file as married filing jointly.

What’s a backdoor Roth?

IRA rules allow you to get around this income restriction by making a Traditional IRA contribution and then converting funds from a Traditional to Roth.

Because your Roth IRA has the advantage of offering tax-free withdrawals in retirement, many people who anticipate being in a higher tax bracket later in life prefer a Roth IRA over a Traditional. A “backdoor Roth” contribution is a way for individuals who might be disallowed from contributing directly to a Roth IRA to still get their retirement savings into a Roth IRA.

A “backdoor Roth” refers to a process in which you make after-tax, non-deductible Traditional IRA contributions, and then you convert your contributions into Roth IRA funds. Contributions to a Traditional IRA may be non-deductible if you’re a high earner and you’re also covered by a retirement plan at work.

After the Traditional IRA contributions are made, those same funds are converted to a Roth IRA—usually within a few business days after the contribution. At Betterment, you can convert right from your account on the next business day after you make your Traditional IRA contribution.

This strategy can be most beneficial tax-wise if you don’t have other deducted IRA funds, including those previously rolled out of a 401(k), SEP IRA, or Simple IRA. If you do, then a portion of your conversion may be taxable. This is an important point that often surprises IRA converters at tax time.

While you can do a conversion at any time during the year, keep in mind that the transaction will be reported on your tax documents for the calendar year in which it occurs, so you’ll have until December 31st of each year to complete a conversion for that tax year.

Because transactions can take a few business days—especially in a multi-step conversion process where you must first deposit into your Traditional IRA and then convert on the next business day—it’s important not to wait until the last minute or you could miss the deadline.

Conversions cannot be undone, so be sure you’ve spoken with a licensed tax professional to make sure this is the right strategy for you. Undoing conversions by recharacterizing used to be an option, but was eliminated due to tax reform in 2017.

Benefits Of A Roth Conversion

  • You generally won’t have to pay taxes when you withdraw money from a Roth IRA at retirement, as long as you’ve had the account for more than five years and are over 59½, or you’ve had the account for more than five years and you are disabled. If you think your tax rate will be the same or higher than your current rate when you withdraw your money, paying taxes now could be beneficial.
  • There are no required minimum distributions as long as you are alive.
  • There are no income limits for converting to a Roth IRA.

Disadvantages Of A Roth Conversion

  • You may have to pay income taxes now on converted amounts that were previously deducted from your income, or from any earnings that you have earned since your contribution. Betterment will not withhold these taxes for you. You may need to make estimated tax payments to avoid an underpayment penalty.
  • The taxable portion of a conversion will be added to your gross income for the year, and could potentially increase your tax bracket overall.
  • Taxpayers with an income or an adjustable gross income (AGI) over $200,000 who file individually, or $250,000 for married couples filing jointly, could be subject to a 3.8% tax on income from interest, dividends, annuities, royalties, and rents which are not derived in the ordinary course of trade or business.

Step-by-Step Instructions For Converting Your IRA

We’ve created a quick process that allows an investor to authorize a Roth conversion on our website in less than a minute.

  1. Log in to your account on a web browser.
  2. Click on Settings in the menu on the left-hand side of the page.
  3. Click the Accounts tab at the top of the page.
  4. Find your Traditional IRA and click the 3 dots that appear off to the right.
  5. Choose the option that says “Convert IRA to Roth.”
  6. You’ll have the option to convert either a partial amount or the full amount.

What exactly is a recharacterization?

In some cases, the IRS allows you to reclassify your IRA contributions. A recharacterization changes your contributions (plus the gains or minus the losses attributed to them) from a Traditional IRA to a Roth IRA, or, from a Roth IRA to a Traditional IRA.

Generally, there are no taxes associated with a recharacterization if the amount you recharacterize includes gains or excludes dollars lost.

You cannot recharacterize an amount that’s more than your allowable maximum annual contribution. You have until each year’s tax filing deadline to recharacterize—unless you file for an extension or you file an amended tax return.

Reasons to Consider A Recharacterization

  • If you made a Roth contribution during the year but discovered later that your income was high enough to reduce the amount you were allowed to contribute—or prohibit you from contributing at all. 
  • If you contributed to a Traditional IRA because you thought your income would be high enough to reduce the amount you would be allowed to contribute (perhaps down to nothing), but your income ended up lower than you’d expected.
  • If you contributed to a Roth IRA, but while preparing your tax return, realize that you’d benefit more from the immediate tax deduction a Traditional IRA contribution would potentially provide.

How To Request A Recharacterization

To recharacterize Roth IRA contributions to Traditional IRA contributions, which is the most common type of recharacterization, simply:

  1. Log in to your Betterment account on a web browser—not the mobile app.
  2. On the left-hand menu, choose Transfers
  3. Scroll down to “Other ways to transfer” and choose “IRA Recharacterization.”
  4. Click through the screens that follow—we’ll ask you some questions about the contributions you would like to recharacterize, and we’ll help calculate the gains or losses that will adjust that amount. If you don’t already have a Traditional IRA into which to move your money, we’ll help you create one. 

There’s a small chance we’ll tell you that your situation would best be handled by contacting our support team—don’t worry, they’re here to help.

If you need to recharacterize Traditional IRA contributions to Roth IRA contributions (which is a less common situation), email our support team. We’ll ask you a series of questions to calculate your gains or losses. If you do not already have a Roth IRA, you’ll need to set one up before emailing us.

When To Request A Recharacterization

You must complete a recharacterization by the IRS mandated filing (or extended filing) deadlines. According to the IRS:

Even if you did not file for an extension, you can still recharacterize your contribution up until the extended filing deadline if you filed your original tax return by the first filing deadline and you will amend the tax return.

If you cannot get your IRA recharacterization completed in time, you may consider whether filing for an extension is appropriate.

We’ll Help You Get Started

Get started or log in to complete your retirement plan and see personalized savings advice, including advice on which type of IRA may be right for you. You can even sync up your existing IRAs, 401(k)s, and other financial accounts to see an overall picture of your finances.

Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.