The backdoor Roth IRA pro-rata rule is a little known but highly important regulation that can have significant implications for anyone executing a backdoor Roth IRA conversion. It stipulates how the IRS will treat pre-tax and after-tax contributions when the taxpayer executes a Roth conversion.
Creating an individual retirement account (IRA) is one of the most popular strategies used while saving for retirement. Most IRAs will fall into one of two categories: traditional IRAs and Roth IRAs.
One of the primary differences between a traditional IRA and a Roth IRA is when you will need to pay taxes. With a traditional IRA, individual taxes can be deferred at the time of contribution and will be paid later upon withdrawal. With a Roth IRA, on the other hand, individual taxes will be paid upfront rather than at withdrawal.
Depending on your life and career circumstances, you may want to consider making a full or partial Roth IRA conversion. When doing this, all or some of the funds from one of your retirement accounts will be converted into a Roth IRA. This conversion can create an immediate tax obligation that has some investors scratching their heads and others simply too spooked to even try initiating a conversion.
Below, we will expound on this tax obligation, diving into how the pro rata rule can affect your tax bill during a Roth IRA conversion.
What Is a Backdoor Roth IRA Conversion?
A backdoor Roth IRA conversion is a method used by higher income individuals to bypass the Roth IRA income limits established by the Internal Revenue Service (IRS). The “backdoor” route can be accessed no matter how high your income might be.
To create a backdoor Roth, retirement savers must convert all or part of a pre-existing retirement account. This action effectively opens a Roth IRA and contributes to the account at the same time.
Reasons to create a backdoor Roth IRA might include expectations for a higher future income, sudden wealth, a new financial strategy, changing family structures, and many others.
The benefits of Roth IRA can be immense. However, the price to create a backdoor Roth IRA can be steep. This is due to the fact that funds directed to Roth IRAs are taxed at the time of contribution, not at the time of withdrawal. This means that making a big contribution all at once, as is often the case when creating a backdoor Roth IRA, can mean that there is abruptly a large chunk of money on which you owe taxes.
Here’s where things get confusing: some of the retirement accounts that you are converting may contain pre-tax dollars, others may contain after-tax dollars, and some may contain a combination of both pre-tax and after-tax dollars. The pro rata rule governs how these mixtures of funds should be treated at the time of conversion in terms of taxes.
What is the Backdoor Roth IRA Pro Rata Rule?
When the IRS determines your backdoor Roth IRA conversion taxes, they will regard all of your current IRA accounts as one entity. This is known as the aggregation rule – no IRA stands alone; instead IRAs are regarded in the aggregate.
The pro rata rule states that taxation of IRA accounts when converted partially or fully to Roth accounts will be calculated proportionally to the fraction of after-tax vs. before-tax contributions. The percentage of funds that are yet to be taxed will be taxed at the pro rata rate, regardless of whether you are transferring all or one of your accounts at once.
Suppose that, when combined, 80 percent of the funds across three of your IRAs are pre-taxed while 20 percent have already been taxed. Let’s suppose you are converting 20 percent of your funds into a Roth IRA. You might be tempted to claim that what you are transferring is the 20 percent that’s already been taxed and therefore you do not owe any new taxes. Unfortunately, this is not the case—due to the pro rate rule, 80 percent of all conversions will be subject to new taxes, regardless of which account the money comes from.
If most (or all) of your contributions have already been taxed, the pro rata rule won’t be as big of a deal. But if you have not paid many (or any) taxes on your total savings, which is often the case, you should expect a higher tax bill.
Further Considerations When Executing a Backdoor IRA Conversion
The pro rata rule is something that should be actively accounted for when planning for retirement. Some other important things to keep in mind include:
· If the only way to pay the tax bill incurred by creating a backdoor Roth IRA is to dip into one of your retirement accounts, you might want to consider waiting—otherwise, you’ll lose some of your investing power.
· After-tax contributions to a traditional IRA will be treated differently than after-tax contributions already in a Roth account.
· There is no limit to how much can be converted via a backdoor Roth IRA, but you’ll want to be mindful of all tax obligations.
A backdoor Roth IRA conversion can make sense in a variety of financial circumstances. However, be sure you understand all tax and legal regulations that apply, and also understand how the pro rata rule applies. Consider working with a Certified Financial Professional who has expertise in retirement planning.
The team of retirement planners and investment advisors at Advanced Retirement Strategies in Bountiful, Utah has the experience and qualifications to execute Roth IRA rollovers and design backdoor Roth IRAs – maneuvers that can create opportunities for a long and comfortable retirement.
Advanced Retirement Strategies financial advisors specialize in helping diligent savers with $250,000 or more of investment and retirement assets (not counting your primary residence) prepare for and then transition into retirement.
We would love the opportunity to assist you. Just head to the get started page and set up a free 15-minute quick consult.