The pro rata rule

In short

A friend of mine once tried to move a few thousand dollars into a Roth IRA and got a tax bill that surprised him. If you earn too much to put money into a Roth directly, you may have heard of the backdoor Roth, where you add after tax money to a traditional IRA and then convert it. The pro rata rule decides how much of that conversion is taxed. It looks at all of your traditional, SEP, and SIMPLE IRA money together, not just the dollars you meant to move. If you hold old pre tax IRA money, part of every conversion will be taxable, no matter which dollars you think you moved. You can check your own mix by looking at your Form 8606 from last year and your year end IRA balances. Before you convert anything, add up every IRA you own and see what share is after tax. That one step shows you the bill before it arrives.

The whole of it

What it is

I once watched a man pour a cup of cream into a pot of black coffee and then ask to take back only the cream. It cannot be done. Once the two are mixed, every spoonful holds a little of each. The pro rata rule treats your IRA money the same way. Pro rata just means in proportion, so each dollar you convert is treated as a slice of the whole pile.

You have probably heard that the backdoor Roth is a tidy two step move. You put money in a traditional IRA without taking a deduction, then you convert it to a Roth. The money you put in after tax is called basis. You already paid income tax on it. The tax law is built to count it that way. The trouble is that the law will not let you point at the basis and say, convert that part only. It makes you spread the basis across every IRA you own.

Which accounts count? Traditional IRAs, SEP IRAs, and SIMPLE IRAs all count. A Roth IRA does not count. A 401(k) at work does not count either, and that fact turns out to be useful. The rule comes from section 408(d)(2) of the Internal Revenue Code, and the IRS explains how to report it on Form 8606 and in the instructions for that form.

How it works

If you are holding both pre tax and after tax IRA money, the math runs in three short steps. First, add up the value of all your traditional, SEP, and SIMPLE IRAs as of December 31 of the year you convert. Then add back the amount you converted during the year. Second, divide your total basis by that sum to get the share that is tax free. Third, apply that share to whatever you converted during the year.

The date matters, and many people miss it. The balance that counts is the one on December 31, not the day you converted. So a rollover or a market swing late in the year changes the numbers you plug in. Write down each input and keep your records.

Here is something worth knowing. The rule only sees IRAs. Some employer plans accept money rolled in from an IRA. When that happens, those pre tax dollars leave the pile that Form 8606 counts. Whether your plan allows it is a question for your plan administrator. The same goes for a solo 401(k) if you run your own business and your plan accepts incoming rollovers.

The numbers, and where to find yours

Some numbers are set by law and change from year to year. The Roth IRA income phase out begins at a modified adjusted gross income of the current figure, which the official source publishes each year for a single filer and the current figure, which the official source publishes each year for a married couple filing together. The most you can put into an IRA for the year is the current figure, which the official source publishes each year. If you are fifty or older, the catch up amount adds the current figure, which the official source publishes each year more. Those figures are published each year by the IRS, so check the current year before you act.

Your own numbers are in your own files. Your basis comes from line 14 of last year's Form 8606, if you filed one. Your year end balances come from the December statements of each IRA you own. Your conversions show up on Form 1099 R from the firm that holds the account. Gather all three. You cannot do this math from memory.

A worked example

Let me tell you about a woman named Dana. She is a dentist with a salary of 260,000 dollars, and she is single. She has an old rollover IRA worth 45,000 dollars, all of it pre tax. This year she puts 7,000 dollars into a new traditional IRA with no deduction, then converts that 7,000 dollars to a Roth.

She figures the conversion costs her nothing in tax. It does not work out that way. On December 31 her IRA balance is only the old 45,000 dollars, because the 7,000 has already moved to the Roth. The rule adds back the amount she converted during the year. So the pile it uses is 45,000 plus 7,000, which is 52,000 dollars.

Her basis is 7,000 dollars. The after tax share is 7,000 divided by 52,000, which is 0.1346, or about 13.46 percent. Her tax free part of the conversion is 7,000 times 0.1346, or about 942 dollars. The rest, 7,000 minus 942, is 6,058 dollars. That amount is taxable income this year.

The size of the amount is not the surprise. The surprise is that the old IRA she forgot about set the whole result. Now picture a different year. Her plan at work accepts rollovers, and she moves the 45,000 dollars into the 401(k) before December 31. Her year end IRA balance is then zero. The pile the rule uses is 0 plus 7,000, which is 7,000 dollars. Her after tax share is 7,000 divided by 7,000, which is 100 percent. Her taxable amount is 7,000 times zero, which is zero. Same money, same goal, very different bill.

Where it goes wrong

I have known careful people to trip here, and none of them were careless. The most common slip is forgetting an old IRA from a past job. It sits in a drawer, so to speak, and the rule still counts it.

Another slip is timing. A rollover into a 401(k) has to be finished by December 31, and paperwork can take weeks. Starting early gives you room for delays.

A third slip is skipping Form 8606. When you make an after tax contribution, you file that form to record your basis. If you do not, the IRS has no record of it, and you could end up paying tax on the same dollars twice. The IRS can also charge a penalty for failing to file it. Keep copies every year.

Last, some folks do the backdoor in two different tax years and assume each year stands alone. Basis carries forward, but the December 31 balance resets the math each year. Each year is its own puzzle.

Questions to answer before you leave this page

Do you know the December 31 value of every traditional, SEP, and SIMPLE IRA you own, including the old ones from past jobs? Have you checked last year's Form 8606 to see what basis you already have on record? Does your employer plan accept rollovers from an IRA, and have you asked the plan administrator how long it takes? Have you worked out your tax free share by dividing basis by your total IRA balance, and have you written down each input so someone else could check it? Is your income near the Roth limit that applies to you this year, and have you looked up the current figure on the IRS site? Would you like a tax professional who knows your whole picture to check your numbers before you convert?