Roth Individual Retirement Accounts (IRAs) can be a great addition to your retirement savings plan. Many people use Roth conversions to get around income limits on Roth IRAs. However, there’s a tricky tax rule called the Pro-Rata rule that can make Roth conversions more complicated than you might think.
If you’re thinking about doing a Roth conversion or need help with your retirement planning, consider talking to a qualified financial advisor. They can provide valuable guidance.
What Is a Roth IRA?
A Roth IRA is a special type of retirement account that lets you invest money after you’ve already paid taxes on it. This means you won’t owe any more taxes when you withdraw your money in retirement. But there are some rules about who can contribute to a Roth IRA. For example, in 2022, married couples filing taxes together had to earn less than $214,000 to make full contributions.
What Is a Backdoor Roth or Roth IRA Conversion?
High-income earners who want to enjoy tax-free withdrawals often use Roth conversions to get around the income limits on regular Roth IRA contributions. Here’s how it works: you take money from a Traditional IRA (where you haven’t paid taxes on it yet), pay taxes on that money, and move it to a Roth IRA. Then, your money can grow tax-free until you retire. People call this a Backdoor Roth conversion.
However, Roth conversions can get tricky if you’ve made non-deductible (after-tax) contributions to a Traditional IRA outside of a 401(k) rollover.
Understanding the Pro-Rata Rule
The Pro-Rata Rule comes into play when deciding how to tax the money you take out of a Traditional IRA and move to a Roth IRA during a conversion. If you’ve never put after-tax money into a Traditional IRA, the entire amount you convert to a Roth IRA will be taxed at your regular income tax rate. This is fairly straightforward. But if your Traditional IRA has both pre-tax (deductible) and after-tax (non-deductible) contributions, the Pro-Rata rule says your Roth conversion will be taxed proportionally based on your pre-tax and after-tax percentages. You can’t choose which funds to convert to avoid the rule.
Calculating Your Taxable Percentage With the Pro-Rata Rule
Here’s an example: Let’s say you have $100,000 in a Traditional IRA, and $7,000 of that is from after-tax contributions. Since you already paid taxes on the $7,000, the IRS won’t tax it again. But you can’t just convert the after-tax money.
To convert $7,000 to a Roth IRA, you need to calculate the taxable percentage. The IRS wants you to include the value of all your non-Roth IRAs as the basis. Here’s the formula:
(after-tax amount) / (total of all non-Roth IRA balances) = non-taxable percentage
(amount to be converted to Roth IRA) x (non-taxable percentage) = amount of after-tax funds converted to Roth IRA
In this case, only 7% of the $100,000 is non-taxable because you’ve already paid taxes on that $7,000. So, if you want to convert $7,000 to a Roth IRA, 93% of the converted amount comes from pre-tax funds, and only 7% comes from after-tax funds. You’ll need to pay taxes on 93%, which is $6,510, of the converted amount. Also, $6,510 of the original non-deductible $7,000 still stays in the Traditional IRA, which could make future withdrawals more complicated.
Roth conversions can be subject to the Pro-Rata rule, which determines how non-Roth IRA funds get taxed when you withdraw them. Some people think they can put after-tax money in a Traditional IRA and then convert it to a Roth IRA to avoid income limits and enjoy tax-free growth. But the Pro-Rata rule stops this. The IRS makes you calculate your taxable contribution percentage and pay a proportionate amount when taking money out of tax-deferred accounts. This can be confusing and lead to unexpected taxes if you’re not aware of the rule.