Funding the tax-free side of the New Three-Legged Stool for retirement can be more difficult for taxpayers with higher incomes. In 2018, joint filers can only make a partial Roth IRA contribution once their adjusted gross income (AGI) exceeds $189,000. No contribution is allowed when AGI exceeds $199,000. For single filers and heads of household, the income phase-out range is $120,000 to $135,000. However, anyone under age 70 ½ can make a non-deductible IRA contribution even if they have passed these income levels. The trick is to get the money moved from an IRA, where earnings are taxable when withdrawn, to the Roth IRA where the earnings will be tax-free.
The Pro-Rata Rule
Converting an IRA to a Roth IRA is a simple process. There are no income limitations. The non-deductible contributions made to an IRA represent after-tax money and therefore are not taxable when you convert. Any deductible contributions made to the IRA plus earnings in all IRA accounts represent pre-tax money. How the IRS accounts for after-tax and pre-tax funds in an IRA when the taxpayer is doing a partial Roth conversion is referred to as the pro-rata rule1.
The formula for the pro-rata calculation is the total after-tax money in all IRAs divided by total value of all IRAs multiplied by the amount converted. For example, a taxpayer makes three $5,000 non-deductible contributions to an IRA over the past couple of years (a total of $15,000). The IRA is now worth $20,000, including growth. Additionally, the taxpayer also has an IRA Rollover account that is worth $80,000. When he or she converts the $20,000 IRA to a Roth, $3,000 will be considered after-tax and $17,000 will be considered pre-tax. ($15,000 divided by $100,000 = 15%; $20,000 x 15% = 3,000)
Things to Consider with Pro-Rata Calculations
Even though the taxpayer only made after-tax contributions to the $20,000 IRA, the IRS says he or she must consider the value of all IRAs to determine the pro-rata portion that is after-tax. In this example, the IRA rollover now has $12,000 in after-tax money. IRAs are considered individual IRAs even for taxpayers filing a joint return. An individual IRA is not combined with the spouse’s IRA balances for purposes of the pro-rata rule.
To make things even trickier, you can’t calculate the exact pro-rata percentage until the end of the tax year. The pro-rata calculation is not based on the balances in the IRAs on the date of the conversion. The total value of all IRAs used in the pro-rata rule include the account values as of December 31st of the year the conversion is made. Any growth (or loss) in the funds remaining in your IRA from now to the end of the year will have an impact on the pro-rata calculation.
This is one reason I recommend in my book, Don’t Retire Broke, that investors allocate their fixed income investments to the IRA and equity investments to their Roth IRA and taxable accounts. For many investors, the change in value may not be significant but it is important to be aware of during tax planning.
Taxpayers must track after-tax balances in IRA accounts on IRS Form 8606. The form should be filed with the tax return in any year the taxpayer makes an after-tax contribution (or rollover after-tax funds from an employer plan to their IRA), and it must be filed in any following year a distribution is taken from the IRA. The form uses the pro-rata calculation to determine the amount of the distribution that is taxable.
A much more significant impact from this rule comes to those who decide to rollover a 401(k) or other type of company plan. Only the total value of IRA accounts is used in the pro-rata rule. 401(k) plan values, 403(b) plans and profit sharing plans are not included in the pro-rata formula. The value of one of these types of accounts would be included if you decided to rollover the plan assets to an IRA during the year.
Let’s go back to my example of the $20,000 Roth conversion. If this same taxpayer decided to rollover a $400,000 401(k) plan to an IRA during the year of conversion, the value of that plan would be included in the formula because it will be in an IRA on December 31st. That means that only $600 of the $20,000 Roth conversion will now be considered after-tax. ($15,000 after-tax divided by $500,000 total IRA assets = 3%. 3% times the $20,000 amount converted = $600). This is very important to keep in mind when doing a rollover in the same year as a Roth conversion if after-tax money is involved.
Finally, 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. However, an inherited IRA is not used in the pro-rata formula2.
For more information on when and why you should convert an IRA to a Roth IRA, please read our recent newsletter on Roth IRA conversions.
- There is no income limitation on a taxpayer’s ability to make a non-deductible IRA contribution.
- The pro-rata rule is used to determine the after-tax amount of a Roth conversion when the taxpayer has both pre-tax and after-tax balances in their IRA(s).
- Company sponsored plans like 401(k)s and 403(b)s are not used in the pro-rata calculation, unless rolled over to an IRA in the year of conversion.
1Also referred to as the IRA Aggregation Rule under IRC Section 408(d)(2)
2Treasury Regulation 1.408-8