Beware of the "pro rata" rule when doing Roth conversions

If you have a tax-deferred retirement account, such as a traditional IRA, and you’ve ever made after-tax contributions to the account, you will be subject to the “pro rata” rule whenever you take money out the account. This applies to distributions from the IRA as well as conversions to a Roth IRA.

With tax-deferred accounts, the main benefit is the ability to get a tax deduction for your contribution in the year of the contribution.

For example, assume you have $100k of wages and you contribute $5k to your traditional IRA. You can potentially get a deduction for that contribution such that you’ll be able to reduce your taxable income by the amount of the contribution. In other words, instead of having to pay tax on $100k of income that year, you’ll only have to pay tax on $95k (i.e. $100k of wages minus the $5k IRA contribution).

On the other hand, with an “after-tax” contribution, you do NOT get a deduction for the contribution. Assuming the same scenario of $100k of wages and $5k of IRA contribution, if you do the contribution on an after-tax basis, you’d have to pay tax on the full $100k of earnings that year.

If all of the money in your traditional IRA is pre-tax (i.e. you took a deduction on the contribution(s) and there have since been earnings on those contributions), you will have to pay tax on every dollar you take out of the account.

Conversely, if you have some after-tax money in your traditional IRA, you won’t have to pay tax on 100% of the money you take out of the account. That’s because some of the money you take out is deemed to be a return of the after-tax money you put in, and the government is kind enough to not tax you a second time on that money. The rest of the withdrawal is deemed to be a removal of the money that has not yet been taxed. The “pro rata” rule is what determines the amount of the withdrawal that’s non-taxable vs taxable.

Assume you have $95k of pre-tax money in your traditional IRA. And further assume you put in another $5kk, but that contribution is on an after-tax basis. You now have $100k in your IRA. 95% of that money has not yet been taxed, 5% of it has.

If you take money out of that IRA, whether through a distribution or a Roth conversion, 95% of that money will be included in your taxable income that year. Only 5% of it will be deemed a removal of a portion of the after-tax money in the account. This is the pro rata rule.

Where the pro rata rule often trips people up is the fact they’re simply not aware it even exists! Like in the example above; an unsuspecting person may think he or she could make the $5k contribution on an after-tax basis and then immediately convert that $5k over to a Roth IRA and not pay any tax on the conversion since tax was already paid on the money before it went it into the IRA. The person will be in for an unwelcomed surprise at tax return time when they realize 95% of that $5k conversion is taxable…

If you want to see firsthand how the pro rata rule works, take a look at IRS Form 8606, which is the form that you’ll have to include in your tax return whenever you do a Roth conversion and/or take any money out of an IRA if it has after-tax money in it.

Also, you can check out my YouTube video, “How to Do a Backdoor Roth Contribution,” that further explains how the pro rata rule works. Additionally, the sixth episode of the Retirement Planning Education podcast details the pro rata rule. Spoiler alert – the pro rata rule has more nuances than what’s discussed in this newsletter.

You don’t have to let the pro rata rule prevent you from doing Roth conversions. But make sure you’re aware of its impacts before you pull the trigger.