The pro-rata rule is an important, though commonly misunderstood, rule that affects the taxation of IRA money. It only comes into play when your traditional IRA consists of both pre-tax and after-tax monies. These after-tax dollars can come from non-deductible IRA contributions or rollovers of after-tax funds from employer plans. Either way, once those monies are in the account, subsequent distributions or conversions are subject to the pro-rata rule. The pro-rata rule does not apply to Roth IRA assets. Instead, Roth IRA distributions are subject to their own set of ordering rules.
The best way to understand the rule is to consider the “cream in the coffee” analogy: when you add cream to a cup of coffee, the two become inextricably mixed. You can no longer take a separate spoonful of coffee without cream or vice versa. Instead, each spoonful is a mix of both coffee and cream. Similarly, when after-tax dollars enter a traditional IRA, subsequent distributions from that account are a mix of both pre-tax and after-tax dollars. For example, if Larry had an IRA balance of $100,000, with $10,000 in after-tax contributions, the after-tax portion would represent 10% of the total account balance. As a result, any distribution would consist of 10% of after-tax dollars and 90% of pre-tax dollars. So, if Larry wanted to withdrawal $10,000, the after-tax (i.e. non-taxable) portion would be $1,000 and the taxable, pre-tax portion, would be $9,000. Going forward, the IRA account would have a total balance of $90,000, with $9,000 in after-tax contribution (still 10% of the total account value).
Similarly, Larry wouldn’t be able to simply convert the $10,000 in after-tax money to a Roth IRA without triggering the pro-rata rule. If Larry tried to do a $10,000 Roth IRA conversion, the same formula applies, and his tax return will now include $9,000 in taxable (converted) funds.
The pro-rata rule also has a special aggregation rule. When you calculate the total IRA balance to determine the taxable/non-taxable percentage, you must include all non-Roth IRA accounts. In addition to other traditional IRA accounts, it also includes any SEP and SIMPLE IRA balances. It does not, however, include Roth IRAs, inherited IRAs, or balances in employer plans. So, in Larry’s example above, if he also had a SIMPLE IRA with a $30,000 balance, his total IRA balance is now $130,000 with $10,000 in after-tax contributions. The after-tax contributions now represent 7.7% of his total IRA balance. A distribution from either account would use this percentage to determine the taxable/non-taxable amounts.
Now there are a couple of exceptions to the pro-rata rule. These distributions can only come from pre-tax funds and therefore do not trigger application of the rule. They include:
- Qualified Charitable Distributions (“QCDs”) – QCDs allow taxpayers age 70 ½ and older to transfer up to $100,000 each year to a charity tax-free. The QCD also counts towards the annual Required Minimum Distribution.
- Qualified HSA Funding Distribution (“QHFDs”) – QHFDs are tax-free transfers from your IRA to your HSA. The amount transferred cannot exceed the maximum annual HSA contribution. For 2018, an individual with Family High Deductible Health Plan (“HDHP”) coverage can contribute up to $6,850 (plus an additional $1,000 for taxpayers age 55 and up). Taxpayers with Self-Only HDHP coverage can contribute a maximum of $3, for the 2018 taxable year 450 (plus the $1,000 catch-up for those ages 55 and older). Finally, you are allowed only one QHFD per lifetime.
- Rollover to Company Plans – If the company plan allows incoming rollovers, you can transfer the pre-tax portion to that plan. However, the funds can only be invested in the options offered by the plan and future distributions are subject to plan rules.
Using any of the exceptions described above is a good way to reduce the pre-tax dollars in a traditional IRA and thereby lower future tax bills. Above, we explained that Larry couldn’t simply convert the $10,000 in after-tax money without triggering the pro-rata rule. However, if Larry was eligible for a company plan that accepted IRA rollovers, he could roll over the pre-tax portion to the plan (i.e., $90,000) leaving just the $10,000 in after-tax money in the IRA. He could then convert the $10,000 after-tax balance to a Roth IRA at little, to no, tax cost! Obviously, the smaller the tax bill, the better! To find out if this is a good strategy for you, discuss your situation with a tax or financial advisor that is well versed in the IRA rules.