how does IRA recharacterization tax work?

Kaye Thomas explains it very well at

When you recharacterize an annual contribution, it is treated as if the contribution were made originally to the IRA it was recharacterized into.

So in your example, the recharacterization means the ultimate outcome is the same (for tax purposes) as if you put the $4000 in the trad IRA in the first place. So the $500 is NOT taxed (because in theory you would have made that same $500 within the trad IRA if the contribution went to the trad IRA in the first place).

There's no IRS form to report this on (unless the recharacterized contribution to the trad IRA is not deductible, in which case you'd use 8606 to report the non-ded contribution, same as if you had made a non-ded trad IRA contribution in the first place).

-- Rich Carreiro snipped-for-privacy@rlcarr.com

Informative answer! I have a similar question and here are the details: I contributed $8000 to my Roth IRA last year on the same day (before April 15th): $4000 for 2006 and $4000 for 2007. My 2007 modified adjusted gross income exceeded the limit to be eligible to contribute to the Roth IRA for 2007. My Roth IRA lost money this year - went from a market value of $8000 to a market value of $7500. What now? Here are the options I have investigated with financial professionals:

1. Recharacterize my account for the money put in for 2007 from a Roth IRA to a Traditional IRA
2. Take out the 00 I invested for 2007 with no tax penalty (because I lost money and I already paid taxes on the 00 I originally put in). Any comments? Thanks

Recharacterization and withdrawal are your two options for avoiding a penalty. In either case the amount will be less than $4,000 since your earnings were negative. See IRS Publication 590.

Thanks! What are advantages/disadvantages of both actions? If I recharacterized the money in a Traditional IRA I would be able to deduct this money, right?

Maybe. The result of recharacterization is that the $4,000 is treated as a traditional IRA contribution rather than a Roth. See Chapter 1 of IRS Publication 590 to see if it would be deductible in your specific case.

If it is deductible, that's the way I'd go, rather than a straight withdrawal.

Thank you for your input, it has been very helpful!