When it comes to doing something to a Traditional or Roth IRA, recharacterize and convert seem to be two similar concepts but they actually have very different meaning. They both involve change. When you recharacterize, you are changing something. When you convert, you are also changing something. Don’t confuse the two though. If you tell your IRA custodian to recharacterize when you meant convert, you may end up paying tax penalties.
I thought long and hard how to distinguish the two. Here’s what I came up with:
Convert operates on a static balance, a pile of money, if you will. The pile sits in a Traditional IRA. You move it to a Roth IRA. That’s converting. It’s a one-way street. You can’t convert money in a Roth IRA to a Traditional IRA. Because convert operates on a static balance, you can convert whenever you want. The money is always there for you to convert.
Recharacterize operates on an action. You can recharacterize a contribution, which is an action; or you can recharacterize a conversion, which is also an action. Because it operates an action, you have a deadline to affect the action. If you don’t recharacterize before the deadline, the original action becomes permanent.
When you recharacterize, you are saying originally I did X, but on second thought never mind, I want to do Y. If you contributed to Traditional IRA but you had second thought, within a deadline you can recharacterize the contribution as a contribution to a Roth IRA (if you otherwise are eligible to contribute). It also goes the other way: if you contributed to Roth IRA but you had second thought, within a deadline you can recharacterize the contribution as a contribution to a Traditional IRA. If you converted from Traditional to Roth but you had second thought, within a deadline you can recharacterize and undo the conversion.
Say you made non-deductible contribution to a Traditional IRA because your income is too high for contributing to a Roth IRA. If instead of converting from that Traditional IRA to Roth IRA, you said recharacterize, now you are in trouble. Your IRA custodian doesn’t know you aren’t eligible to contribute to Roth to begin with. They will do as you say. Come tax time, your recharacterized contribution will trigger a penalty.
Don’t confuse convert and recharacterize. The letter ‘a’ in recharacterize stands for action. Convert operates on a pile of money; there’s no deadline. Recharacterize operates on an action; it has a deadline.
[Photo credit: Flickr user Cauldron Graphix]