Roth conversions are becoming more popular as a way to bypass Roth IRA income limits. However, Roth conversions are subject to the Pro-Rata rule.
What is an IRA Conversion?
A Roth conversion is a way to bypass the income limits on Roth contributions by high wage earners. There is no limit to how much you can convert to a Roth IRA. This conversion is often called a Backdoor Roth.
Since a Backdoor Roth conversion involves withdrawing Traditional IRA funds and transferring them to a Roth IRA, the Pro-Rata rule applies.
What is the Pro-Rata rule?
The Pro-Rata rule applies if your Traditional IRA contains both pre-tax and after-tax contributions. The Pro-Rata Rule is used to determine the ratio that should be applied in determining how much of the conversion is pre-tax vs after tax. You are not able to choose only the after-tax portion when doing a conversion.
If you have not contributed post-tax dollars into a traditional IRA, the total amount converted is taxed at your normal income tax rate and the Pro-Rata rule does not apply.
The Pro-Rata rule is used to prevent people from dodging the Roth income limit to manipulate funds to decrease their tax bill.
How do I make the calculation?
The IRS requires that you include all your non-Roth IRAs as the basis.
The equation to use to figure the taxable amount is as follows:
- (non-deductible 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
John has contributed $5000 in after tax contributions. His total non Roth IRA balance is $80,000. That means 6.25 % of his contributions are not taxable ($5,000 non deductible amount)/$80,000 (total non-Roth IRA balance = .0625). If John converts $50,000 into a Traditional Roth, 6.25% of the $50,000, or $46875, is not taxable. The remaining $3125 is taxable when converted.