By Andy Ives, CFP®, AIF®
IRA Analyst
The pro-rata rule dictates that when an IRA contains both non-deductible (after-tax) and deductible (pre-tax) funds, then each dollar withdrawn (or converted) from the IRA will contain a percentage of tax-free and taxable funds based on the ratio of after-tax funds vs. the entire balance in all your IRAs. When there is a mix of pre- and after-tax dollars, you cannot withdraw (or convert) just the non-deductible funds and pay no tax.
When we say “all of your IRAs,” we mean that the pro-rata rule looks not only at a person’s traditional IRAs, but also at any SEP and SIMPLE plans that he may also own. For the pro-rata rule, the IRS considers all of these accounts as one big bucket of money. You cannot “shield” certain dollars by moving them to their own separate account at a different custodian. Note that inherited IRAs, Roth IRAs and work plans, like a 401(k), are NOT factored into the pro-rata math.
Now that we know which accounts will be involved, how does the pro-rata math work? Using a round-number example, assume a person (Ralph) has a $100,000 IRA. Ralph does not own any other IRAs, SEP or SIMPLE plans. Within this $100,000 IRA, there is $10,000 of after-tax (non-deductible) money. How those after-tax dollars got there is irrelevant. Maybe they were rolled over from a work plan. Maybe Ralph made non-deductible contributions over the past few years. Regardless, Ralph wants to do a partial Roth conversion.
The ratio of pre-tax to after-tax dollars in this $100K IRA is 9:1. As such, the pro-rata rule dictates that ANY Roth conversion Ralph does will be 90% taxable. This is true if Ralph converts $20,000, $50,000 or the whole account. Ralph cannot cherry pick the $10,000 of after-tax dollars and only convert those.
Ralph instructs his financial advisor to process a $10,000 Roth conversion. Based on the pro-rata rule, Ralph will owe tax on $9,000 of this conversion. Ralph is not a happy camper. He complains to his advisor that “This is double tax! I already paid tax on that $10,000, and now I’m paying it again.” Ralph’s financial advisor calmly explains the situation and walks Ralph off the proverbial ledge. In fact, Ralph is not paying “double tax” as he feared.
The Explanation: As mentioned, with Ralph’s $10,000 Roth conversion, we cannot convert only the $10,000 of after-tax dollars. Based on Ralph’s 9:1 ratio, we carve off $9,000 from the pre-tax portion of his IRA balance and carve off another $1,000 from the after-tax portion of his IRA. These are the dollars that get converted, and Ralph pays tax on $9,000 of his pre-tax funds.
After the conversion, Ralph has a $10,000 Roth IRA that is all after-tax dollars. What remains in Ralph’s traditional IRA? The balance is down to $90,000. Since we took $9,000 of the pre-tax dollars and $1,000 of the after-tax dollars for the conversion, the mix in his traditional IRA is now $81,000 pre-tax, and $9,000 after-tax. And what is that ratio? Still 9:1.
Combined (traditional + Roth IRA), Ralph still has $100,000. Between the two IRAs, Ralph now owns $19,000 of after-tax dollars. There was no “double tax” on the $10,000. Pro-rata simply carved off a percentage of each type of dollar (pre-tax and after-tax) and converted the proportionate amount.
If you have technical questions you would like to have answered, be sure to submit them to mailbag@irahelp.com, to be answered on an upcoming Slott Report Mailbag, published every Thursday.