The Pro-Rata Rule: How Roth Conversions Get Taxed

All conversions from a Traditional, SEP or Simple IRA to a Roth are subject to the pro rata rule (Internal Revenue Code 408(d)(2)). The IRS combines the total value of your traditional, SEP and simple IRAs for this purpose. Therefore, when making a conversion, it is taxed by the ratio of the after-tax portion of your IRAs to their overall value. Although you cannot withdraw only your after-tax contributions, if you have pre-tax funds in your IRAs, then part of the conversion will be taxable.

That last sentence ruins the plan most people have for Roth conversions. People think they've already been taxed when they make an after-tax (nondeductible) contribution, so now they are free to transfer those contributions to a Roth without being taxed again. However, the IRS doesn't see your after-tax contribution as separate from all of your pre-tax dollars in your IRAs. The mix will be subject to income tax. This is the single biggest reason a backdoor Roth IRA turns into a tax liability.

What is the pro-rata rule?

The pro rata rule is a tax rule that prevents you from moving only the after-tax portion of your Individual Retirement Account (IRA) monies to a Roth. Internal Revenue Code Section 408(d)(2) requires you to treat all of your individual retirement plans as if they were one contract when determining the taxable amount of any distribution(s) or conversion(s).^[1] In other words, your Traditional IRAs, your SEPs from self employment, and your SIMPLEs from a job are merged together in a single account for this purpose. Thus, when you move funds to a new plan or account type (i.e., convert), the IRS will determine what percentage of the total value of your account represents after-tax contributions and only that proportionate share of your conversion proceeds will be eligible for exclusion from gross income. The rest is ordinary income. You do not get to designate which dollars you moved.

How does the pro-rata rule calculate your tax?

One fraction applies to the rule. The numerator will be your after-tax basis (the sum of the nondeductible contributions that you have made) and the denominator will be your end-of-year total of your traditional, SEP and SIMPLE IRAs. This percentage is how much of what you converted is tax-free. IRS Publication 590-B goes through the same calculation as a worksheet on Form 8606.^[2] Working out an example case makes the rule feel less abstract. Suppose you make a $7,500 nondeductible contribution but you also have $67,500 of pre-tax money in a rollover IRA. So, your total is $75,000 and your basis is $7,500, so your basis fraction is 10 percent. Convert the whole $7,500 and the conversion split will look like this:

The real issue here is the distortion. You used $7,500 of previously taxed funds, and believed you had a clean shot at converting, but 90 percent of that conversion will still be taxed. Your own $7,500 was never altered. The pre-tax portion of your account sitting next to it lowered the ratio and now that basis is left in your remaining IRA to gradually recover over time through all future conversions.

A large pre-tax balance doesn't just hurt you on one year. It also lengthens the number of years of tax free recovery.

Can you convert only your after-tax contributions?

No, and this is the way in which the greatest amount of money is lost by people due to their beliefs. The standard assumption made by many individuals is that since they have already paid taxes on contributions they cannot deduct, they can then convert only that amount of contributions and owe nothing. However, the pro rata rule blocks that result outright. The Code 408(d)(2) requires one pot treatment. Therefore, the IRS will treat a $7,500 conversion from a $75,000 pot as if the conversion were a 90 percent pre-tax transaction regardless of which account you actually wrote the check from.^[1] The practical procedure would be to verify the size of your pre-tax IRA balance before you make any conversions. Then, you can run your numbers to determine what portion of your potential conversion is taxable prior to making any commitments. If the size of your pre-tax balance is large enough, consider clearing it prior to making the conversion(s), or you could choose to accept that most of your conversion(s) are taxable. The rule is not punitive toward any wrongdoing. Rather, it is simply a methodical explanation of how the math functions with regard to your transactions and assuming differently leads to a surprise 1099-R and an underpayment upon filing.

When is the pro-rata rule measured?

The time period from which the ratio is derived (for your fractional interest), is the amount you have at the end of December of the year you are converting to a Roth, not the amount you had on the day of conversion. Line 6 of Form 8606 will ask for the aggregate value of all of your traditional IRAs as of December 31, including any outstanding rollovers, and the IRS Instructions for Form 8606 clearly state this year-end snapshot.^[3] This is why many get tripped up thinking it's okay to make a same-day transfer. You can convert a non-deductible contribution in January when your account has almost nothing in it, then roll a $60,000 401(k) into a traditional IRA by November. The December 31 balance now includes that $60,000, and your January conversion is retroactively taxed as mostly pre-tax. It is the measurement date that makes a late-year rollover dangerous if you converted early in the year.

How do you avoid the pro-rata rule?

The most straightforward way to get around the pro rata rule is to completely deplete the pre-tax portion of your IRA before converting. Employer-sponsored retirement accounts offer a way out. A 401(k), 403(b) or governmental 457(b) account does not constitute an IRA, therefore it never enters the pro rata calculation, and if you move your pre-tax IRA funds into an employer sponsored plan which allows for incoming rollovers, they will also be removed from the denominator entirely. Move all eligible assets prior to December 31 of your conversion year, since the end-of-year balance determines the denominator. Once you have rolled over, the only thing that will remain in your IRA is your after-tax basis, and a conversion of that basis is virtually tax free.

A SIMPLE IRA is the sharp exception on the way out. As per Code 408(d)(3)(G), there will be no ability to move your SIMPLE IRA money into anything other than another SIMPLE IRA during its first 2 years, measured from your first contribution. Therefore, you will not be able to avoid the pro rata rule by rolling your SIMPLE IRA into a 401(k) plan until this period has closed.^[4] The full SIMPLE IRA rollover rules cover that 2-year clock. Whatever portion of your money you converted, you should report it on Form 8606 so that the IRS can credit the basis that you previously paid taxes on. In addition, the separate Roth IRA withdrawal rules then govern how much of your withdrawal will be tax free.

The Bottom Line

The pro rata rule will combine your traditional IRA, SEPs and Simple IRAs and will calculate the amount of tax due from each Roth conversion based upon the proportion of after-tax basis in relation to the total balance of all of them as of December 31. You cannot convert only after-tax dollars. First, determine how much money is in your pre-tax account and, if it is large, transfer it to a 401(k) before you make the conversion. This way, the conversion remains almost totally tax free.

This educational guide describes the IRS rules for the pro rata rule and Roth conversions. It is not investment, legal, or tax advice. Your account documents and current IRS limits control. Talk to your tax advisor about your circumstances.