Pro-Rata Rule for Backdoor Roth IRA

Written by

John Foote

Published on

14 Nov
2024

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The backdoor Roth IRA conversion is a useful, albeit complex, strategy for high-income earners who are phased out of contributing directly to a Roth IRA due to income limits. However, one critical element that is often overlooked is the pro-rata rule. This rule can have a significant impact on your tax liability when executing a backdoor Roth IRA, so understanding it is crucial. In this post, I’ll first explain the backdoor Roth IRA, then break down the pro-rata rule and its implications.
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What is a Backdoor Roth IRA?
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For individuals whose income exceeds the limits to contribute directly to a Roth IRA, the "backdoor" Roth IRA provides a workaround. The process involves the following steps:‍

1. Contribute to a Traditional IRA :

This contribution is typically non-deductible (after-tax) because your income is above the threshold to take a deduction on the contribution.

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2. Convert the funds to a Roth IRA :

You then convert the balance in your Traditional IRA to a Roth IRA.

This method allows high-income earners to essentially bypass the income limits on Roth IRA contributions. Since the contribution was made with after-tax dollars, the conversion typically does not result in additional taxation.

However, if you make deductible contributions to a Traditional IRA (i.e., pre-tax contributions), those funds will be subject to taxation upon conversion. This is where the pro-rata rule becomes relevant, as it dictates how much of the conversion is taxable.

What is the Pro-Rata Rule?
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The pro-rata rule comes into play when your Traditional IRA contains a mix of pre-tax and non-deductible (after-tax) contributions. It prevents you from converting only the after-tax (non-deductible) portion of your IRA and leaving the pre-tax portion behind to avoid taxes. Instead, the IRS requires that any Roth conversion be done on a pro-rata basis, meaning both pre-tax and after-tax funds are converted proportionally.

Example: How the Pro-Rata Rule Works

Let’s say in 2024, you decide to contribute $7,000 to your Traditional IRA and then convert it to a Roth IRA. But you already had $3,000 in the account from previous years, which consisted of pre-tax contributions.

You can’t simply convert just the $7,000 and avoid taxes by claiming it as entirely after-tax dollars. The pro-rata rule will apply to the entire balance. Here’s how it works:‍

Your total IRA balance before conversion is $10,000 ($7,000 new contribution + $3,000 pre-existing).

Of that $10,000, 30% ($3,000/$10,000) is pre-tax.

As a result, when you convert the $7,000, 30% of the conversion—or $2,100—will be treated as pre-tax dollars and taxed as ordinary income. The remaining 70% ($4,900) will be non-taxable since it represents after-tax contributions.

If your entire IRA consisted of after-tax contributions, no additional taxes would be owed on the conversion. However, because of the pro-rata rule, the tax applies to the pre-tax portion.

All IRA Accounts Are Included
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It’s important to understand that the pro-rata rule applies across all your IRA accounts, not just the Traditional IRA you're converting from. This includes SEP IRAs, SIMPLE IRAs, and any other IRA-type accounts you hold. For example, if you have a SEP IRA with significant pre-tax contributions, those balances will also be factored into the pro-rata calculation, potentially increasing the portion of the conversion that is taxable.

How to Avoid the Pro-Rata Rule Impact

One common strategy to minimize the tax hit from the pro-rata rule is to roll over pre-tax IRA dollars into an employer-sponsored plan, such as a 401(k), if available. Qualified employer plans like 401(k)s are not subject to the pro-rata rule, which means you can effectively “isolate” your after-tax contributions in your IRA and convert them tax-free.

This is why many financial planners recommend opening a Solo 401(k) (if you're self-employed) or rolling over pre-tax IRA balances to an employer 401(k) if you're planning to use the backdoor Roth IRA strategy. By doing so, you can reduce or eliminate the taxable portion of your conversion.

Reporting the Backdoor Roth IRA

It’s essential to accurately report your backdoor Roth IRA transactions on IRS Form 8606, which tracks nondeductible IRA contributions and conversions. This form will calculate the taxable portion of your Roth conversion using the pro-rata rule. Mistakes on Form 8606 can result in overpaying taxes or underreporting your tax liability, which may lead to IRS scrutiny.

Final Thoughts

The pro-rata rule can significantly complicate a backdoor Roth IRA conversion, especially if you have multiple IRA accounts or a mix of pre-tax and after-tax dollars. However, with careful planning, such as rolling pre-tax dollars into a 401(k), you can minimize the tax burden.If you’re unsure how the pro-rata rule applies to your situation or need help optimizing your retirement contributions, feel free to contact Modoo Strategy LLC. We can help you navigate the complexities and ensure that your backdoor Roth IRA is executed smoothly._‍

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