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/$66,000 = 9.1%). This is the percent that would be tax free on the conversion. Above all, 90.9% would be TAXABLE. Your attempt to convert $6,000 of a non-deductible IRA (after tax IRA contribution) just resulted in 90.9% 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.

Do you have questions about Roth IRA Conversion and the Pro Rata Rule?

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35 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.

    • Chirag January 1, 2021 at 11:35 am #

      What if you rolled over old company 401k plan into your new company 401k plan. Would that come in play with pro rate rule during conversion or is it only if i had rolled old compnay 401k into a new rollover traditional ira ? 401k account is not considered as tranditional ira correct? I would need to open new traditional and roth ira accounts.

  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.

    • David Waldrop, CFP® November 23, 2020 at 3:50 pm #

      Hi Ralph, please see DIY Tax Kathy’s correction. I hope it helps.

  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.

  4. John September 12, 2020 at 1:37 pm #

    Just following the example above it seems like you are paying double tax on the 90%. You pay tax on 100% of the non-deductible IRA, when you set that up. Then following the Pro-Rata Rule you pay taxes on 90% of the $6,000 which has been backdoored into the Roth. Is that right??

    • David Waldrop, CFP® September 14, 2020 at 7:35 am #

      Hi John, It’s a great question and thank you for contributing to the conversation. When you make a non-deductible IRA contribution of $6,000, that $6,000 is after tax money. The assumption is that those funds resulted from income you earned, but that isn’t always the case (i.e. inherited funds, sold a car, etc.). Non-deductible simply indicates you’re not reducing your taxable income by $6,000. It’s not completely accurate to assume the $6,000 was taxed nor is it clear what rate it what taxed at. However, if we leave all of that aside and assume the $6,000 non-deductible contribution had already been taxed, it is fair to state this is taxed twice. Remember, the IRS is fine with people converting their deductible IRAs to Roth IRAs because that results in the funds being taxed. The pro-rata rule is there so people can’t avoid taxes by only converting their non-deductible IRAs and not their deductible IRAs that would ordinarily result taxation. In any case, once those funds are in the Roth (however they get there) they will ultimate grow without further taxes and ultimately allow for tax-free withdrawals in retirement. Which is HUGE!

  5. JONATHAN October 11, 2020 at 8:15 am #

    I believe one way to reduce the impact of the pro-rata rule is to “reduce” the total amount of your pre-tax IRA, and this can be done by rolling those IRA funds into your company 401k plan, if your company permits this. My question is, does rolling pre-tax IRA funds into an immediate annuity (with payments for life) similarly exclude those funds from the pro-rate calculation?

    • David Waldrop, CFP® October 12, 2020 at 7:09 am #

      Excellent question and points raised Jonathon. Thank you for contributing to the conversation. First, it’s important to remember that many people do not have a 401(k) to roll IRA funds into. If you have a 401(k) and your plan allows for rollover into the 401(k), this will help minitgate the impact of the pro-rata rule (as you stated). Many folks end up with an IRA due to rolling out of a 401(k) plan due to termination of employment and may no longer have a 401(k) plan. As far as the “rolling into an immediate annuity” I don’t have a concrete answer. However, it stands to reason that it’s still an IRA even though it’s an immediate annuity and would be included in the pro-rata rule. If you find information that says something different, please be sure to post here in the comments.

      • Tom October 13, 2020 at 8:07 pm #

        Hi David. My company allows me to roll my IRA into my 401k. I have a traditional IRA with about 4k being non-deductible with about a 20k balance. If I rolled my pre tax into my 401k, how do we determine where the gains would be from? Is it all equal even though the 4K may not have been in there as long as the other contributions? Essentially I want to get rid of any balance in my tIRA while it’s still a relatively low balance so I can be 100% Roth like I’ve now been doing the past few years. By the way, the only reason the 4K was non deductible was because I went over income limit that year. What’s the best way to proceed? Thanks a lot!

        • David Waldrop, CFP® October 14, 2020 at 12:26 pm #

          Hi Tom and thank you for the question. Before I start, this is not tax advice nor a recommendation. Also, probably best to consult a tax advisor on this. Some of this also depends on the cutodian and their process (or lack of one) for handling these transactions. Consider this example. If you were to withdraw the $20k, you would likely be taxed on $16k (assuming your over age 59 1/2). If you took out $10k, you would be taxed on $8,000. This is based on the ratio of the non-deductible amount against the total balance. In theory, you could rollover $16,000 to the 401(k). Then, convert the $4,000 to the Roth IRA and thus avoid the pro-rata rule. HOWEVER, I’m not suggesting you do that without careful consultation with a tax advisor. The IRS generally frowns upon financial transactions that aim to avoid taxes. If you discover additional details about transactions like this, please post them in the comments as others may find it helpful.

      • Robert April 16, 2021 at 4:23 am #

        Question regarding this scenario as it has recently come up for me. I was awarded additional funds from a prior employer’s pension. That employer took those funds and placed them into a traditional IRA. I am not interested in investing post tax dollars (non deductible) into a traditional IRA and immediately rolling over into the ROTH IRA. Obviously i want to avoid any pro-rata or triggers with the IRS so i was thinking that i should be able to
        1) take the original pre-tax traditional IRA awarded from a previous employer and roll over into my existing pre-tax 401k
        2) Contribute 6k into traditional IRA and immediately Rollover into a Roth IRA

        Would that be the clean-legal and legitimate way of clearing the original traditional IRA and investing into a Roth IRA without being impacted by Pro Rata and the IRS

        • David Waldrop, CFP® April 16, 2021 at 6:42 am #

          Hi Robert, It is my understanding that pre-tax IRA funds rolled into a 401(k) are NOT part of the pro-rata calculation. Be sure to consult a tax advisor for your specific situation.

  6. Jonathan Perkes October 12, 2020 at 1:09 pm #

    Thanks David. I found information that confirms your statement: it’s still regarded as IRA funds and therefore does get included in the pro-rata calculation.

  7. Nick D October 21, 2020 at 7:28 am #

    Hi David. I have a question about the tax implications of subsequent years. My interpretation of the pro rata rule is that Roth conversions are done “equally” between your before-tax and after-tax money. In your example, 90% of the IRA funds were deductible and 10% were non-deductible, so it makes some amount of sense that 90% of the conversion will be taxable.

    What happens though in subsequent years? Let’s assume (from your example) I don’t do anything and instead convert $10k out of my $60k to Roth. Would 90% be taxed or 100% be taxed? 90% makes more sense to me, because in the previous conversion I really only moved 10% of my non-deductible IRA to Roth.

    • David Waldrop, CFP® October 21, 2020 at 8:09 am #

      Hi Nick, Thanks for commenting and being part of the conversation. I’m not sure I completely follow the question. I will say that we need to distinguish between converting all pre-tax dollars vs. non-deductible amounts. The pro-rata rule is specifically looking at the non-deductible contribution compared to other pre-tax IRAs. In future years, the calculation is done again and will reflect new balances (account values). The whole rationalle of the pro-rata rule is to make sure people don’t avoid tax by only converting the non-deductible contributions. I recognize this might not completely address your question. I would be happy to schedule a consulting call with you to get your situation squared away. Send me an email and we’ll get it scheduled. It’s very affordable and will help make sure you don’t make a costly mistake. Just let me know.

      • Nick D October 21, 2020 at 10:02 am #

        Let me ask a different question to help clarify.

        In your above example, after taxation what is the status of the funds? Here is my understanding based on the pro-rata rule:

        In the Traditional IRA: $54,600 in deductible funds and $5400 in non-deductible funds
        In the Roth IRA: $6000
        Out of Pocket: some effective tax rate based on $5400 that was considered taxable income.

        Do I have that correct?

        • David Waldrop, CFP® October 21, 2020 at 10:41 am #

          In my example, the $6,000 non-deductible contribution upon conversion is subject to tax, not the Traditional IRA. Based on the pro-rata rule, $5,400 of the non-deductible contribution is subject to tax. The $6,000 goes into the Roth IRA and is no longer considered non-deductible. When you do your taxes, you’ll owe tax on the $5,400 based on an assumed tax rate for your income situation. The $60,000 remains pre-tax and its tax status hasn’t changed. What you end up with is:

          $6,000 Roth IRA (after-tax, future tax free)
          $60,000 Traditional (pre-tax, future taxable)

          If someone sees an error in this and/or can provide a better and more accurate explanation, please leave it here in the comments.

          • DIY Tax Kathy November 23, 2020 at 2:12 pm #

            I believe the responses to Ralph in February and to Nick are incorrect. In your example, the denominator should be $66000, as Ralph indicated (reference Form 8606 line 9, which is sum of remaining traditional IRA balance=$60000 and amount converted to Roth=$6000). The non-deductible portion ($6000) is then divided by the total $66000 to get 0.0909 on line 10, or $545 as non-taxable portion of conversion and $5455 as taxable conversion. The $60000 remaining in the traditional IRA is now also subject to the pro-rata rule where $5455 is now the basis, and $54,545 is pre-tax (9.1% after-tax, 90.9% pre-tax).

            In other words, the $6000 non-deductible contribution was split during the conversion. Only $545 was converted to Roth, the rest stayed in the traditional IRA. $5455 from the original rollover money was taxed in the conversion (Form 8606 line 18, also entered on Form 1040 Line 4b).

            If that’s not correct, please explain.

          • David Waldrop, CFP® November 23, 2020 at 3:33 pm #

            Thank you, Kathy, for providing this detail. I will update the article with the correction. Thank you for contributing to the conversation.

        • David Waldrop, CFP® November 23, 2020 at 3:49 pm #

          Hi Nick, please see DIY Tax Kathy’s correction. I hope it helps.

  8. Reza Tabatabai January 1, 2021 at 10:26 pm #

    How does the pro rata rule come in to play for married couples? I have multiple traditional Ira’s and rollover Ira’s both with a large percentage that is pretax. My wife does not have any traditional or rollover Ira’s. Could she do a back door conversion and would the pro rata rule only apply to her accounts?

    • David Waldrop, CFP® January 1, 2021 at 10:42 pm #

      Great question! I believe spouses IRAs are not aggregated together for the purposes of the pro-rata rule. This leads to reason that each spouse is looked at separately even though you’re married and filing jointly. Be sure to consult a tax advisor before acting on information provided in the comment section. Speaking of, any tax professionals want to chime in on this one?

  9. Jody January 11, 2021 at 12:31 pm #

    Hi David, in 2019 and 2000 l moved and paid taxes on money that l had in a traditional IRA to my Roth IRA.
    I have had Roth IRA over 10 years. My plan is to live off my dividends from my Roth so l can leave the money to my 25 year old son that has Asperger’s is this feasible with the first in first out rule.
    And does the 5 year rule apply for me to wait on my 2019 rollover to 2023, 2000 to 2024 before l will have meet the 5 year rule or have l fulfilled the 5 year rule because l have had the Roth opened 5 years. Thank you

    • David Waldrop, CFP® January 12, 2021 at 11:05 am #

      Hi Jody, Thank you for the question and contributing to the conversation. I’m sure you can understand that I need to be very careful about providing answers to a specific situation. Answering this without knowing more about you and having a formal client/advisor relationship wouldn’t be the right thing to do. If you’d like to schedule some consulting time, you can email me via http://www.theastuteadvisor.com. I’d be happy to talk with you in more detail about this. If anyone else cares to weigh in and answer Jody, please feel free.

  10. Jerry January 24, 2021 at 7:12 pm #

    Hi David –

    I have a question regarding pro-rata and annuities. I recently consolidated all my IRA’s into a solo 401k for the purpose of avoiding triggering pro-rata for when I do my backdoor Roth IRA conversion each year (I’m self employed). Right now, I put $6K into my traditional IRA (which has a $0 balance) and then do the backdoor Roth. However, I also have a deferred annuity account and I was wondering if that is considered an IRA and would therefore trigger pro-rata on the Backdoor Roth?

    • David Waldrop, CFP® January 25, 2021 at 10:26 am #

      Hi Jerry, thank you for the question. You need to be sure that the annuity isn’t an IRA. Some deferred annuities are IRAs (qualified annuity). Other’s are not IRAs (non-qualified annuity). My understanding is that non-qualified annuities are not included in the pro-rata calculation. This is educational in nature and should not be considered investment or tax advice.

  11. Joyce January 24, 2021 at 8:36 pm #

    Hi David, I have $1k pre-tax in my Rollover IRA. I don’t have other traditional IRA money now. To get around with pro-rata rules (‘clear’ the pre-tax money in traditional IRA, then contributing after-tax money to Traditional IRA, finally converting to Roth IRA), do you recommend me doing an early withdrawal of this $1k? The penalty to this $1k is totally acceptable, and $1k won’t push up my bracket limit. Any other risk that I miss out? Appreciate it!

    • David Waldrop, CFP® January 25, 2021 at 10:22 am #

      Hi Joyce, thank you for the question. You would be paying tax AND penatly on the $1,000. Is that more than what you would owe via the pro rata rule?

      • Joyce January 25, 2021 at 3:25 pm #

        Got it.. I did my math and decided to reverse rollover to my current employer’s 401k account. Thanks David!

  12. Ann March 15, 2021 at 3:53 pm #

    Hi David, I contributed $5,500 tax deductible to IRA in 2017, and $6000 non-deductible to IRA in 2018, 2019, and 2020. I converted all funds to Roth IRA in 2020. How does the pro-rata rule calculated and what would be my total basis? Thank you!

  13. connor October 27, 2021 at 12:41 pm #

    So if I have a 60k Ira balance make a 6k non deductible contribution and convert 6k 90% of which is taxable. When I go to make the no deductible contribution the next year how much money do I have after tax 12k or 6k after the contribution? Does the 6k accumulate or does it decrease after the conversion amount?
    Thanks

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