Roth IRAs and The Pro-Rata Rule | Rodgers & Associates

Follow This Formula When Converting an IRA to a Roth

Roth IRAs are a dependable way to build retirement savings because the earnings are tax-free. Yet for taxpayers with higher incomes, these vehicles can be more difficult to leverage.

Consider the 2022 parameters. For those filing jointly, when the adjusted gross income (AGI) exceeds 204,000, only a partial contri­bution is allowed. When AGI exceeds $214,000, no contri­bution is allowed. For single filers and heads of house­holds, the income threshold is $129,000 to $144,000.

These limita­tions, however, do not apply to standard IRAs. Anyone with quali­fying earned income can make a non-deductible IRA contri­bution regardless of income. So for some high-income taxpayers, one strategy is to move money from a standard IRA, where future earnings are taxable when withdrawn, to a Roth IRA, where earnings are tax-free.

Understanding the Pro-Rata Rule

Converting an IRA to a Roth IRA is a simple process. While there aren’t income limita­tions at play, you’ll need to identify the difference between after-tax and pre-tax money. Non-deductible contri­bu­tions to an IRA represent after-tax money, which means they aren’t taxable when you convert them. Any deductible IRA contri­bu­tions, on the other hand, plus earnings from all IRA accounts, represent pre-tax money.

When a taxpayer is doing a partial Roth conversion, the IRS follows a formula called the pro-rata rule1 to account for after-tax and pre-tax funds. The formula for the pro-rata calcu­lation is the total after-tax money in all IRAs, divided by the total value of all IRAs, multi­plied by the amount converted:

Pro-rata calcu­lation =
total after-tax money in all IRAs ÷ total value of all IRAs x amount converted

Let’s assume a tax payer makes three $6,000 non-deductible contri­bu­tions to an IRA over the past three years for a total of $18, 000. The IRA today is worth $23,000, including market growth. Let’s also assume the taxpayer has a separate IRA rollover account that is worth $77,000.

If they decide to convert the $23, 000 IRA to a Roth IRA, $4, 140 will be considered after-tax and $18,860 will be considered pre-tax according to the formula:

$18,000 in after-tax contri­bu­tions ÷ $100,000 total IRA balances ($23,000 + $77,000) = 18%
After-tax portion = $23,000 x18% = $ 4,140
Pre-tax portion = $23,000 — $4,140 = $18,860

Things to Consider with the Pro-Rata Rule

If you’re trying to apply the pro-rata formula to your own situation, here are a few factors to keep in mind.

  • You’ll need to consider the value of all IRAs to determine the pro-rata portion that is after-tax, even if you only made after-tax contri­bu­tions to one account. In our example, $18,860 of the 23,000 conversion was taxable and $4,410 was tax-free, leaving $13,590 in non-deductible contri­bu­tions remaining.
  • IRAs are considered individual IRAs even for taxpayers filing a joint return. An individual IRA is not combined with the spouse’s IRA for purposes of the pro-rata rule.
  • You will use IRS Form 8606 to track your after-tax IRA balances. The form should be filed with your tax return in any year you make an after-tax contri­bution to your IRA (or roll over after-tax funds from an employer plan). It must also be filed in any following year a distri­b­ution is taken from the IRA.
  • You can’t calculate the exact pro-rata percentage until the end of the tax year. Rather than being based on the date of conversion, the pro-rata calcu­lation is based on IRA balances as of December 31st the year the conversion was made. Any growth (or loss) in the funds from the date of conversion to the end of the year will impact the calculation.
  • 401(k) and 403(b) plans, as well as profit sharing plans, are not included in the pro-rata formula. You would only include the value of these accounts if you decided to roll over the plan assets to an IRA during that year.
  • Lastly, SEP IRA values and SIMPLE IRA values are included in the defin­ition of all IRAs. Even though these types of accounts are company sponsored, they must be included in the pro-rata calcu­lation. An inherited IRA, however, is not used in the calcu­lation.2

Origi­nally Posted March 31, 2018

  1. Also referred to as the IRA Aggre­gation Rule underIRC Section 408(d)(2).
  2. Treasury Regulation 1.408–8