What is the Pro Rata rule for Roth conversions?
The Pro Rata rule for Roth conversions states that if you have any other deductible IRAs (i.e. a previous 401k that you’ve rolled over), the conversion of any contributions becomes a taxable event that you’ll need to pay taxes on upfront.
The Pro Rata rule for Roth conversions determines whether or not your conversion will be taxable! For taxation purposes, the IRS will look at your entire IRA holdings (even if they are in different accounts), not just the traditional IRA you are converting to a Roth IRA, and will determine what your tax bill will be based upon a ratio of IRA assets that have already been taxed to those IRA assets in total.
The IRS determines the tax on this conversion based on the value of all of your IRA assets. For example Jane, a high income earner, already has $94,500 in an IRA account, all of which has never been taxed. She decides on January 2nd to put $5,500 into a new traditional IRA. The next day she converts the new traditional non-deductible IRA to a Roth IRA. Jane’s income is too high for her to make a direct contribution into a Roth IRA, but there’s no income limit on conversions. Unlike Bill she has $94,500 in other IRAs (previously non-taxed), so her total IRA assets are now $100,000. When she converts $5,500 to a Roth IRA, the IRS pro-rates her tax basis on the previous taxation of her total IRA assets, therefore making this conversion 94.5% taxable ($94,500/100,000 = 94.5%).
So if you plan on using this backdoor IRA strategy, you want to be clear as to whether or not you have any other IRAs. As you can see, this can be a confusing area and this is where we can help. If you are a high income earner we would be happy to review your situation to determine if this strategy is in your best interest.
Also, please remember that your spouse’s IRA is separate from yours.
Stay tuned for my next blog post, Benefits of a Roth IRA!
Want to learn more? Give us a call at 412-521-2732.
– James Lange