Understanding the Pro-Rata Rule

Roth IRAs can be a valuable tool in your retirement plan. With the possibility of tax-free growth and withdrawals, it’s no surprise that people choose to execute Roth conversions to avoid the usual income and contribution limits. However, people that hastily make these conversions may not realize when they’ve triggered the pro-rata rule. As a result, they wind up with a complicated tax bill they’re not expecting.

Here’s what you need to know about the pro-rata rule and how it relates to your retirement plan.

A Review of Roth IRAs

To understand the pro-rata rule, it’s helpful to first understand Roth IRAs and Backdoor Roth IRAs. Unlike Traditional IRAs, which use pre-tax dollars, a Roth IRA allows the account owner to contribute after-tax money, let their investments grow tax-free, and withdraw without paying additional taxes in retirement.

However, Roth IRA owners are limited to certain contribution and income limits. In 2023, single tax filers must have a modified adjusted gross income (MAGI) of less than $138,000 to make a full contribution. Married or joint-filing taxpayers must have a MAGI of less than $218,000. The contribution limit for people under 50 is $6,500, or $7,500 for people 50 and older.

To bypass these limits and take advantage of a Roth IRA’s tax benefits, high-income earners will often use a Backdoor Roth strategy, which enables them to convert after-tax funds in a Traditional IRA to a Roth account, where earnings won’t be taxed.

Where Does the Pro-Rata Rule Come In?

When making their Roth IRA conversions, people often assume that they can simply convert their after-tax IRA contributions. This isn’t usually the case. If you have a blend of deductible and non-deductible money in any non-roth-IRA-accounts, these funds cannot be separated (often referred to as the cream-in-your-coffee rule), so the pro-rata rule is triggered when you make your conversion.

The pro-rata rule dictates that your Roth conversion will be taxed proportionately to the pre-tax and after-tax dollars in the entire balance of your IRA plans, with the caveat that account owners are not allowed to choose which funds they convert. The goal here is to ensure people don’t manipulate their funds to try to avoid the taxes typically involved in the conversion process.

To determine the non-taxable percentage of your conversion, you’d follow this basic pro-rata formula:

(non-deductible amount) / (total of all non-Roth IRA balances) = non-taxable percentage

Let’s say you have $50,000 in a Traditional IRA and $10,000 came from non-deductible contributions (contributions that have already been taxed), you might think you can convert that $10,000 to a Roth IRA without paying taxes again. However, because the IRS doesn’t allow you to select only after-tax funds, you’ll need to determine how much of your total IRA funds are taxable. Using the formula above, that would look like: $10,000/$50,000 = .20 or 20%

This means the $10,000 you want to convert will come from 80% pre-tax funds and 20% after-tax funds, so you’ll need to pay taxes on 80% (or $8,000) of that amount.

Other Applications for Pro-Rata Rules

While backdoor Roth IRA conversions are a common application for the pro-rata rule, investors are subject to the rule whenever they have non-Roth assets in both tax categories. If, for example, you rolled over never-taxed funds from a 401(k) into a Traditional IRA that contains already-taxed contributions, the pro-rata rule would be applied when you later take distributions.

The pro-rata rule can also cause complications when taking distributions directly from an employer-sponsored 401(k), which, in most cases, will require you to withdraw on a pro-rata basis. In other words, you would need to withdraw proportionately from all of your holdings, so there’s a chance you may end up selling an investment at an unideal time.

The Pro-Rata Rule and Your Financial Planning

Financial planning is all about building and protecting your wealth to meet your financial goals, and implementing tax strategies can help you get there. However, people may jump too quickly to take advantage of a tax-saving opportunity. When it comes to Roth IRAs, it’s not uncommon for people to rush into making a conversion without understanding all of the tax implications. As a result, they end up owing more than they anticipated. To safeguard your hard-earned money, understanding the pro-rata rule must be a critical step in your financial planning.

Want to learn more about how the pro-rata rule impacts your investments and financial plan? >Reach out to Ironwood Wealth Management today.