The Pro-Rata Rule Explained – You are NOT Getting Double Taxed

By Andy Ives, CFP®, AIF®
IRA Analyst
Follow Us on Twitter: @theslottreport

SCENARIO: Teddy, age 60, has an existing Traditional IRA with a current balance of $93,000. This is all deductible, pre-tax money. Teddy would like to contribute to a Roth IRA, but his income level exceeds the Roth IRA income threshold. To skirt this problem, Teddy makes a 2021 $7,000 non-deductible contribution to his Traditional IRA with the idea to then covert the $7,000 as a Backdoor Roth. Teddy erroneously thinks that his $7,000 conversion will be tax free. He is surprised to learn that the bulk of the conversion is, in fact, taxable. Teddy complains that he is being double taxed because he “already paid the taxes on that $7,000 basis.”

Teddy does not understand the pro-rata rule. He is not being double taxed. The pro-rata rule dictates that when an IRA contains both nondeductible and deductible funds, each dollar withdrawn (or converted) from the IRA will contain a percentage of tax-free and taxable funds. This ratio is based on the percentage of after-tax dollars in the entire balance in all of a person’s Traditional IRAs, SEP and SIMPLE plans.

Teddy cannot cherry-pick only the after-tax funds and just convert those. Also, it would make no difference if Teddy contributed the $7,000 to a totally different IRA at a different custodian. The IRS sees all IRAs, SEPs and SIMPLEs under a person’s name as one big bucket of money. So, what is the “pro-rata math” on Teddy’s Backdoor Roth conversion, and how will his accounts be impacted after the transaction?

Teddy has no SEP or SIMPLE plans. His only IRA is the one that had $93,000 of all pre-tax dollars. Once Teddy contributed the $7,000 of after-tax dollars, his IRA value was $100,000. The total percentage of after-tax dollars was 7%, and the total percentage of pre-tax dollars was 93%. Based on these percentages, the pro-rata rule dictates that every withdrawal or conversion will include a proportionate amount of pre-tax and after-tax dollars. As such, Teddy’s Backdoor Roth conversion of $7,000 in not all after-tax. It is 93% pre-tax and 7% after-tax. This results in a split of $6,510 taxable dollars and $490 after-tax dollars moving into Teddy’s Roth IRA.

After the conversion, Teddy still has $100,000 in his IRAs, divided as follows:

• $7,000 in a Roth IRA that is all after-tax money.
   
• $93,000 in a Traditional IRA – but that Traditional IRA now also contains $6,510 of after-tax basis. (And what percentage of $93,000 is $6,510? It is 7%!)

Teddy did not pay double tax. He still has his after-tax dollars, with most of those monies still in his Traditional IRA. He was only able to convert a portion based on the pro-rata split. In Teddy’s case, he converted 7% of his Traditional IRA, which meant that he was only converting 7% of his after-tax dollars. If Teddy had converted $50,000 (half his total IRA), then he would have also converted half ($3,500) of his after-tax dollars.

Since the pro-rata rule stipulates that a proportionate amount of pre- and after-tax dollars get converted, Teddy will have to monitor the basis in his Traditional IRA. Each year going forward, for almost any withdrawal or conversion, Teddy will have to reconcile his pro-rata mix. There are exceptions to the pro-rata rule and ways to clean this up…but that is for a future article.