Roth IRA Conversion – The Pro Rata Rule Is Lurking

Roth IRA Conversion - The Pro Rata Rule is Lurking

Roth IRA Conversion – The Pro Rata Rule is Lurking

A Roth IRA conversion and Roth IRAs in general can be powerful tools in a retirement saver's toolkit. The potential to accumulate a bucket of funds to be used tax free in retirement is very attractive. This is especially true when you realize how much of your 401(k) or Traditional IRAs will be taxed in the future.

Roth IRA – A Brief Review

Before we dive into Roth IRA conversion and the pro rata rule, you'll want to review how a Roth IRA differs from a Traditional IRA. Most retirement accounts require withdrawals in retirement to be taxed as ordinary income. Roth IRAs allow withdrawals to be taken tax free. For a more complete description of the difference between tax deferred and tax free please see TAX-DEFERRED VS TAX-FREE INVESTMENT ACCOUNTS. With a Roth IRA, there is no upfront reduction in taxable income in the year of the contribution is made. These retirement accounts are funded with after tax dollars. Once these funds are added to the Roth IRA, they grow without annual tax on dividends, interest, or capital gains. So long as the future withdrawals are “qualified distributions,” they are considered tax free.

Roth IRA – Income Limits

Despite the desire to contribute to a Roth IRA, some savers find they are phased out. This is due to their income being over an amount specified by the IRS. Therefore, because their income is over the limit, they are not eligible to contribute to a Roth IRA.

Income limits that apply to Roth IRAs are based on Modified Adjusted Gross Income or MAGI. This can make things a bit confusing because we don't often think of our income in these terms. Referring back to your tax returns can help. It's best to think of MAGI as your Adjusted Gross Income with certain deductions added back in.

For 2019, the phase out range for Roth IRAs is:

  • $193,000 – $203,000 for filing status “married filing jointly” or “qualifying widow(er)
  • $122,000 – $137,000 for filing status “single”

In 2020, the phase out range for Roth IRAs is:

  • $196,000 – $206,000 for filing status “married filing jointly” or “qualifying widow(er)
  • $124,000 – $139,000 for filing status “single”

*For a more detailed look at the phase out range for a specific filing status please see: ROTH IRA CONTRIBUTION LIMITS

While there are income limits placed on Roth IRA contributions, there are no income limits to contribute to a non-deductible IRA.  A non-deductible IRA is simply a regular IRA contribution without a deduction from income also known as “after tax.” However, don't mistake income limits for contribution limits. There are still contribution limits for non-deductible IRAs.

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Roth IRA Conversion – The Pro Rata Rule Is Lurking

This is where a Roth IRA conversion comes in. Converting “after tax” monies from a non-deductible IRA to a Roth IRA should result in a reduced tax bill when compared to converting a Traditional IRA (pre-tax funds). Most importantly, it allows a high income earner to get money into a Roth IRA when they would otherwise be ineligible. As a result, this strategy has been dubbed the “back door Roth IRA.”

In this scenario, one would contribute funds to a non-deductible IRA and then convert those funds to a Roth IRA. There is no income limitation on converting to a Roth IRA but, the Pro Rata Rule can catch many by surprise.

The Pro Rata Rule prevents people from only converting non-deductible IRAs (after tax) to Roth IRAs and thus avoiding the taxes that would normally be involved in the conversion process. This rule requires you to consider ALL of your IRAs as the same account. Therefore, if you have a Traditional IRA, an IRA Rollover, SIMPLE IRA or SEP IRA, those balances are considered when it comes to determining your tax owed on the conversion.

Roth IRA Contribution Limits - Rollovers and Distributions

Roth IRA Contribution Limits – Rollovers and Distributions

Roth IRA Pro Rata Rule Example

After planning to make a $6,000 Roth IRA contribution, you discover that your modified adjusted gross income is beyond the limit and you are not eligible. You then try a “back door Roth IRA” and make a $6,000 non-deductible IRA contribution (after tax) with the intent to convert it to a Roth IRA and avoid the tax on the conversion. The problem is that you already have a $60,000 IRA from an old 401(k) from a previous employer. As a result, the Pro Rata Rule requires you to include that as part of the calculation for taxes owed on the conversion.

Therefore, you must add up all of your non-Roth IRA funds ($60,000 IRA Rollover) and add up all of your non-deductible IRAs ($6,000 ) and determine the percentage of after tax dollars. In this scenario ($6,000/$60,000 = 10%). This is the percent that would be tax free on the conversion. Above all, 90% would be TAXABLE. Your attempt to convert $6,000 of a non-deductible IRA (after tax IRA contribution) just resulted in 90% of that transaction being taxable.

Roth IRA Conversion – Considerations

  1.  Converting Traditional IRA pre-tax dollars to a Roth IRA could push you into a higher tax bracket
  2.  Tax-free withdrawals from the Roth IRA require that you follow the Roth IRA Five Year Waiting Rule
  3.  Roth IRAs have no required minimum distributions or RMDs
  4.  Inheriting a Roth IRA from anyone other than your spouse will require RMDs
  5.  May be eligible to make contributions after age 70 1/2

If you've found yourself phased out of contributing to a Roth IRA and are considering a Roth IRA conversion, proceed with caution. Sometimes, in our haste to take advantage of an opporyunity, we rush in without carefully examining all of the pros and cons. Despite our good intentions we can go from the frying pan into the fire.

To sum up, Roth IRAs can be a very powerful retirement planning tool. It's never a good feeling being excluded from participating in something that can benefit us. The income limitations placed on Roth IRAs has been a sore spot for many. While I try to remind people that being phased out of participating in a Roth IRA can be a good problem to have, not everyone is satisfied with that perspective. Before you start a Roth IRA conversion, proceed with caution, the Pro Rata Rule is lurking.

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5 Responses to Roth IRA Conversion – The Pro Rata Rule Is Lurking

  1. Charles Little December 4, 2018 at 3:24 pm #

    I have a more basic question which no one seems to really get to when explaining the use of Roth IRAs. Here are the facts:
    I am 70 years old
    I converted $50,000 from an SEP IRA to a Roth IRA in December of 2014
    I now want to begin converting $50,000 per year from the same SEP IRA to the same Roth IRA
    I paid taxes on the 2014 converted amount and will pay taxes on each successive conversion

    My question is — do the earnings from each successive converted SEP IRA contribution fall under a new 5 year rule or do all future earnings fall under the original 2014 conversion’s 5-year rule allowing me to withdraw any amount from my Roth IRA at any time after January 1, 2019 without paying taxes on future earnings even though they may be derived from conversions that have not yet met the 5-year rule. I understand the first in first out rule applies and so I would only be taking earnings after the original investments had been withdrawn but in a significant financial emergency I might have to empty the account of all converted amounts plus all earnings.

    Now after reading the article on the Pro Rata Rule, I also need to sort out if that impacts me.

  2. Ralph Pitz February 21, 2020 at 11:50 am #

    Are you sure the denominator in your example above ($60,000) is correct? I thought it should be $66,000 and therefore the ratio would be 6,000/ 66,000

    • David Waldrop, CFP® February 21, 2020 at 1:59 pm #

      Hi Ralph, thank you for the question. I believe this is correct. Step one: add up all pre-tax IRAs. In this case, there is a $60k IRA rollover (pre-tax). This becomes the denominator. Step two: divide the $6,000 non-deductible IRA by the denominator. Result equals 10%. 10% of the $6,000 conversion will be tax free. 90% will be taxable. Of course, I’m human so it’s possible I have it wrong. If you think so, please tell me specifically why it’s wrong. That way we can all learn from it. Thanks again for reading and contributing to the conversation.

  3. Adam June 10, 2020 at 2:29 pm #

    This was very helpful, thank you.

    Am I correct in understanding that if someone has no monies in any IRA (just employer sponsored 401k, 403b and 457b) then there would be no taxes? Could that person do a backdoor roth each year with no tax penalty, or would they need to count the value that previously been backdoored?

    • David Waldrop, CFP® June 10, 2020 at 2:36 pm #

      Hi Adam, Thank you for your question. Amounts that are “backdoored” are NOT included in the pro-rata rule.

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