What is the Pro Rata Rule?

Hello again! Welcome back to another edition of Written by A(ndrew) I(ntelligence). Today I will be focusing on the pro rata rule and how it will impact you.

As I spoke in my previous blog, the Back Door Roth IRA strategy is a way for high earners to bypass the income limits on direct contributions to a Roth IRA.

BUT one catch with the Back Door strategy is the pro rata rule

The pro rata rule is triggered when a taxpayer takes either a distribution or performs a Roth conversion from a Traditional, SEP, or SIMPLE IRA that contains a mix of pre-tax and after-tax dollars.

Unfortunately for us, the IRS does not allow us to carve out and only convert the clean, after-tax money. This is because the IRS views all of an individual’s non-inherited IRAs as one single account. The taxable % is determined on December 31st of the year the conversion was was made.

Say you have the below three account balances

• Old Traditional IRA: $92,000

• New Traditional IRA: $0

• Roth IRA: $50,000

This year you are looking to use $7,500 towards the Back Door Strategy.

You expect to contribute $7,500 as after tax dollars to the new Traditional IRA, convert it to Roth immediately, and now have $7,500 tax free added to the Roth balance.

!!! The IRS says no way !!!

In reality, your total aggregate balance at the end of the year (assuming you do no additional conversions) would be the sum of your $7,500 after tax contribution, and your pretax $92,500 old Traditional IRA balance ($100,000).

Your after tax ratio is then $7,500/$100,000, meaning 7.5%of your backdoor conversion is tax free, and the remaining 92.5% is sibject to ordinary income tax.

!!! This defeats the whole purpose of the conversion !!!

So while the Back Door Roth strategy can be an easy way to get some tax free retirement dollars, make sure you are doing it correctly and not paying unnecessary taxes.

Look into the below bullets if you have a Traditional balance and are looking for ways to avoid the pro rata rule.

• Rip the bandaid off - convert all pre-tax balances to Roth (major tax implications)

• Reverse Rollover - roll pre-tax balances into your current 401(k) plan as qualified employer plans are exempt from the IRA aggregation rule.

Worried you may be subject to the pro rata rule this year? Looking for options? Book time on my calendar HERE and I can review your situation!

Until next time,

Andrew

The information presented in this blog is the opinion of the author and does not reflect the views of any other person or entity unless specified. The information provided is believed to be reliable and obtained from reliable sources, but no liability is accepted for inaccuracies. The information provided is for informational purposes and should not be construed as advice. Advisory services offered through AMD Wealth Management LLC, an investment adviser registered with the state of New Jersey.