How to Determine Contribution Limits for a Recharacterized IRA

Investors "recharacterize" traditional IRA into a Roth IRA or vice versa. One reason is taxes: Contributions to a traditional IRA are tax exempt until you withdraw the money, while money you put into a Roth is tax-free when you take it out. Recharacterizing IRAs or IRA contributions can also avoid tax penalties for exceeding the limits on annual contributions.

Difficulty: Challenging

Instructions

1. Learn the law for IRA contributions. Tax law limits the maximum annual contribution in 2008 at $5,000 — $6,000 for account owners over 50 — with $500 increases after that to account for inflation.

2. Determine your adjusted gross income. This is your taxable income, less allowable deductions, and plays a role in how much you can contribute to an IRA in a given year.

3. Factor in your 401(k). If you or your spouse have a 401(k) through your employer, the limits on your traditional IRA contributions will be reduced or eliminated. If there's no 401(k), you can donate the maximum.

4. Check your adjusted gross income against the IRS rules to see if your contribution limit must be reduced for the year. If you're recharacterizing a traditional IRA into a Roth IRA, the income ceiling is higher, but the ceiling applies even if you don't have a 401(k).

Tips & Warnings

• You can recharacterize an entire IRA or recharacterize only the contributions you made in the previous year. Check with your tax or finance professionals about which is more advantageous for you.
• If you don't discover you're over the contribution limit for your IRA until the following year, you can retroactively recharacterize your contributions up until the April 15 tax deadline. The IRS will usually grant an automatic six month extension beyond that.
• If you're recharacterizing part of your IRA, the formula for figuring gains and losses on the contribution is quite complicated. Since there are financial penalties for mistakes, be careful.

Resources

• IRS guide to IRAs.