3 Things You Must Know About the Pro-Rata Rule
By Jeffery Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
The pro-rata rule - another complicated intersection of moving IRA money. It's an important rule to know when thinking about distributing funds from your IRA, so we decided to break it down below into 3 things you need to know.
1. The Basics: In general, your traditional IRA is a retirement account that contains pre-tax money, but in some cases, you may also have after-tax money in your traditional IRA as well. Generally, these after-tax funds accumulate as you make nondeductible IRA contributions or if you rollover after-tax funds from an employer plan. Once these funds are in your IRA, it’s not so easy to get them out… at least without emptying your entire IRA balance… thanks to the pro-rata rule.
The pro-rata rule – which we refer to as "the cream in the coffee rule" – essentially says that as you distribute funds from your IRA, those distributions are comprised of a proportional amount of pre and post-tax funds in relation to your cumulative IRA funds – across all of your IRA accounts. For instance, if you have $100,000 of cumulative IRA money, $20,000 of which are after-tax funds, then 20% of your total IRA balance is after-tax money. As such, 20% of a typical IRA distribution you take will be after-tax funds and tax-free, while the remaining 80% will be of pre-tax funds that you’ll owe tax on. So, for example, if you took a $30,000 distribution, $6,000 (20% x $30,000) would be tax-free and the remaining $24,000 (80% x $30,000) would be taxable.
2. Not all Your Retirement Funds are Included in the Calculation
When calculating the amount of your IRA distribution that will be taxable and the amount that will be tax-free, it’s crucial to use your cumulative non-Roth IRA balance, as noted above. This not only includes money in all your traditional IRAs, but also any funds you may have in SEP or SIMPLE IRAs. If you also have money in non-IRA employer plans, such as a 401(k), those funds do not factor into the pro-rata rule for your IRA. You also will not include inherited IRAs with owned IRAs.
3. It’s Only a General Rule
The pro-rata rule, requiring that pre- and post-tax funds come out of an IRA in proportion, is the general rule, but like just about everything else in the IRA world, there are plenty of exceptions. For instance, qualified HSA (health savings account) funding distributions, qualified charitable distributions (currently expired but widely expected to be reinstated later this year) and rollovers to employer plans all are exceptions to the pro-rata rule and can only be made using pre-tax IRA funds.
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