Pro-Rata Tax Rules Still Apply When Converting IRA Funds to Roth IRA

Tuesday, September 30, 2014

By Joe Cicchinelli, IRA Technical Expert
Follow on Twitter: @JoeCiccEdSlott

Since the release of IRS Notice 2014-54 on September 18, 2014, there has been some confusion over whether the rules in that Notice apply to converting IRA funds to a Roth IRA. Notice 2014-54 provides favorable guidance for people with after-tax money in their company retirement plan, such as a 401(k). As a result of the Notice, if you have after-tax funds (basis) in your company plan, you may be able to convert some of your retirement savings to a Roth IRA tax-free.

The IRS said that if you have a 401(k) with pre and after-tax money, you can take a distribution and roll over (convert) just the after-tax money to a Roth IRA tax-free, while rolling the remaining pre-tax money over to a traditional IRA if certain rules are followed. ( See the September 18, 2014 Slott Report article “New Guidance Opens the Door to Tax-free Roth IRA Conversions of Certain Retirement Funds” and the September 24, 2014 Slott Report article “After Tax-Money in Company Retirement Plan: 5 Questions You Need Answered After IRS Notice 2014-54” for more information.)

Since the release of Notice of 2014-54, some have questioned whether the rules in that Notice apply to converting IRA funds to a Roth IRA. The answer is they do NOT apply. If you want to convert IRA funds to a Roth IRA and you have after-tax funds such as non-deductible IRA contributions in any IRA, you generally cannot convert only the after-tax funds to a Roth IRA tax-free. The reason is because the pro-rata tax rules apply to IRA distributions.

Under the pro-rata IRA tax rules, when any IRA contains both after-tax and pre-tax funds, then each dollar withdrawn from any IRA will contain a percentage of tax free and taxable funds based on the percentage of all after-tax funds in all IRAs to the entire balance in all of your IRAs. You generally cannot just withdraw (or convert) the after-tax funds and pay no tax. Also, you must total all of your non-Roth IRA balances (including SIMPLE and SEP IRAs).

 

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