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some high-income taxpayers, one strategy is to move money from a standard IRA, where future earnings are taxable when withdrawn, to a Roth IRA, where earnings are tax-free.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
- Also referred to as the IRA Aggregation Rule underIRC Section 408(d)(2).
- Treasury Regulation 1.408–8