A Guide to the Pro-Rata Rule and Roth IRAs

Introduction

• Roth Individual Retirement Accounts (IRAs) serve as a powerful tool in retirement plans.
• Roth conversions are popular for bypassing Roth IRA income limits.
• Pro-Rata rule may impose a complex tax bill on Roth conversions.

What Is a Roth IRA?

• Roth IRAs are tax-leveraged retirement accounts.
• Allow growth of after-tax money without retirement taxes.
• Governed by rules for tax-free withdrawals.
• 2022 income limit for contributions by married couples filing jointly: $214,000.

Roth IRA Conversion (Backdoor Roth)

• High earners use Roth conversions to bypass income limits.
• Involves transferring Traditional IRA funds (after paying taxes) to Roth IRA for tax-free growth.
• Often referred to as "Backdoor Roth".
• Tax implications may arise, especially with non-deductible contributions to Traditional IRAs.

Understanding the Pro-Rata Rule

• Determines taxation of tax-deferred money on withdrawal.
• Applies to Roth conversions involving Traditional IRA funds.
• If only pre-tax contributions exist, conversion taxed at normal rate.
• Mixed pre-tax and after-tax contributions require proportional taxation.

Calculation Example

• For $100,000 in a Traditional IRA with $7,000 non-deductible contributions:
  • Non-taxable percentage: $7,000 / $100,000 = 7%
  • Conversion assumes 93% pre-tax and 7% after-tax funds.
  • Taxes apply to 93% of converted funds.

Avoiding the Pro-Rata Rule

• Pro-Rata rule requires considering all IRAs as a single entity for tax calculations.
• Separate accounts for pre-tax and after-tax contributions can simplify conversions.
• Rolling pre-tax funds into a 401(k) can isolate after-tax contributions.
• Consulting a financial advisor is recommended.

Conclusion

• Backdoor Roth conversions are subject to the Pro-Rata rule for taxation.
• IRS requires calculation of taxable contribution percentage for withdrawals.
• Surprises in tax bills possible without proper understanding.

Retirement Planning Tips

• Consider consulting a financial advisor for long-term planning.
• Use online tools, such as retirement calculators, to estimate retirement needs.

Additional Resources

• Find a financial advisor
• Retirement Calculator