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pro rata rule

Roth Individual Retirement Accounts (IRAs) can prove a powerful tool in your retirement plan, so it may come as no surprise that Roth conversions are a popular method of bypassing Roth IRA income limits. However, many retirement savers are unaware that Roth conversions can trigger a complicated tax bill because of a little-known regulation called the Pro-Rata rule. Here’s a guide on how that works.

A financial advisor could help you plan for retirement and help you determine if a Roth conversion is the best option for you. Find a qualified advisor today.

What Is a Roth IRA?

Roth IRAs are tax-leveraged retirement accounts that allow you to grow after-tax money without paying more taxes at retirement. As a result, they are subject to specific rules that govern tax-free withdrawals.

Because withdrawals can be tax- and penalty-free, Roth IRAs restrict contributions to earners who make less than a certain income. In 2022, the limit for married couples filing joint taxes is $214,000.

What Is a Backdoor Roth or Roth IRA Conversion?

High-earners who wish to benefit from tax-free withdrawals often turn to Roth conversions as a way to bypass the strict income limits on Roth contributions, especially because there is no limit to how much you can convert over to a Roth IRA. The idea is to take Traditional IRA funds, pay taxes on the amount you wish to transfer into a Roth account and then benefit from tax-free growth until retirement. This conversion is often called a Backdoor Roth contribution.

However, many retirement savers are unaware of the tax implications that such a process can trigger. Roth IRAs are funded using after-tax dollars, so many assume that moving tax-deferred money to a Roth IRA means you will pay taxes on the amount to be converted and that’s it. Unfortunately, that’s only true if you have never contributed non-deductible, or after-tax, money to a Traditional IRA.

If you have ever topped up your Traditional IRA outside of a 401(k) rollover, your conversion tax bill may be more complicated than you think.

What Is the Pro-Rata Rule?

pro rata rule

The Pro-Rata Rule is used to determine how tax-deferred money should be taxed upon withdrawal. Since a Backdoor Roth conversion involves withdrawing Traditional IRA funds and transferring them to a Roth IRA, the Pro-Rata rule applies.

If you have never contributed after-tax money to a Traditional IRA, the total amount you convert to a Roth IRA will be taxed at your normal income tax rate. The process is relatively straightforward. However, if your Traditional IRA contains both pre-tax (deductible) and after-tax (non-deductible) contributions, the Pro-Rata rule dictates that your Roth conversion will be taxed proportionate to your pre- and post-tax percentages. To prevent people from skirting the Roth income limit and manipulating funds to lower their tax bill, you are not allowed to choose which funds you convert.

How Do You Calculate Your Taxable Percentage With the Pro-Rata Rule?

Let’s say you have $100,000 in a Traditional IRA, $7,000 of which came from non-deductible contributions. Because you’ve already paid taxes on $7,000, the IRS will not require you to pay taxes on that amount twice. Some retirement savers believe that, since they’ve already paid taxes on that amount, they can then convert $7,000 to a Roth IRA without paying taxes again. By law, though, you cannot dictate that your Roth conversion will only use those after-tax funds.

If you’d like to convert $7,000 to a Roth IRA, you will need to calculate how much of your IRA funds are actually taxable. The IRS requires you to include the value of all your non-Roth IRAs as the basis. The formula for tax purposes looks like this:

  • (non-deductible amount) / (total of all non-Roth IRA balances) = non-taxable percentage
  • (amount to be converted to Roth IRA) x (non-taxable percentage) = amount of after-tax funds converted to Roth IRA

In other words, 7% of the $100,000 is non-taxable since you already paid taxes on those $7,000. But if you want to convert $7,000 to a Roth IRA, in reality, the converted amount comes from 93% pre-tax funds and only 7% after-tax funds. You’ll have to pay taxes on 93%, or $6,510, of the converted amount. By the same token, that means $6,510 of the original non-deductible $7,000 is still in the Traditional IRA, and any future after-tax contributions to your non-Roth IRAs will further complicate your Pro-Rata percentage, making future withdrawals messier than you might assume.

Bottom Line

pro rata rule

Backdoor Roth conversions are subject to the Pro-Rata rule, which dictates how non-Roth IRA funds are taxed at withdrawal. Some retirement savers believe that they can contribute after-tax money to a Traditional IRA and then convert the funds to a Roth IRA as a way to avoid Roth IRA income limits and benefit from tax-free growth, but the Pro-Rata rule prevents them from doing so. Instead, the IRS requires taxpayers to calculate their taxable contribution percentage and pay a proportionate amount when withdrawing from tax-deferred accounts. This can complicate matters and may result in an unexpected tax bill for the unwary.

Retirement Planning Tips

  • Not sure if a Roth conversion can help you save more for retirement? For a solid, long-term financial plan, consider speaking with a qualified financial advisor. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Use SmartAsset’s free retirement calculator to get a good first estimate of how much money you’ll need to retire.

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Photo credit: ©iStock.com/Kameleon007, ©iStock.com/Khanchit Khirisutchalual, ©iStock.com/kupicoo

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