4 Things to Know About Roth IRA Conversions and Pro-Rata Rule
By Beverly DeVeny, Chief IRA Analyst
Follow Me on Twitter: @BevIRAEdSlott
Here is what you need to know about IRA-to-Roth IRA conversions and the pro-rata rule. The pro-rata rule also applies to employer plan retirement plan distributions, but it is applied differently.
- For conversion purposes, all of your IRAs are treated as one BIG IRA account. This includes any SEP and SIMPLE IRAs you might have.
Example: You have three IRAs; one has $50,000 in contributions and earnings, one is a SEP IRA with a balance of $40,000, one has $10,000 in after-tax contributions, but no earnings. You convert the $10,000 IRA to a Roth IRA. For tax purposes, you’re looked at as having one $100,000 IRA and the $10,000 is considered to come out of that one big IRA.
- Because all of your IRAs are treated as one account, you generally cannot segregate the after-tax contributions. Any conversion done from any IRA account will be deemed to consist of some pre-tax funds and some after-tax funds. This is the pro-rata rule. Here's more detail on the rule.
Example Continued: Under the pro-rata rule, your IRA account has a balance of $100,000 ($50,000 + $40,000 + $10,000 = $100,000). 10% of your balance is after-tax funds. So, any distribution you take will be 10% tax free and 90% taxable.
- Your conversion and the pro-rata calculation are both reported on IRS Form 8606, which must be filed with your income tax return.
- The pro-rata calculation is not based on the balances in your IRAs on the date of the conversion. The account balance used is as of year-end of the year of the transaction. This means that you generally should not roll over employer retirement plan balances in the same year you do a Roth conversion. They will be included in the pro-rata calculation and will skew the results.
Example Continued: Let’s assume that the Roth conversion took place in August. Then, in October, you moved $100,000 from your 401(k) plan to your IRA. Assuming no gains or losses in the interim, when you complete the Form 8606, your year-end IRA balance will be $200,000 ($100,000 from the plan + $90,000 still in the IRAs + the $10,000 conversion, which gets added back in according to the pro-rata formula). Now, only 5% of the account balance is after-tax funds, so only 5% of the conversion amount is tax free.
Let’s change the example a little. Now let’s assume that of the $100,000 in your 401(k) plan, $40,000 is after-tax contributions. When the 401(k) is moved into the IRA, your $200,000 balance contains $50,000 ($10,000 from the IRA + $40,000 from the 401(k)), or 25%, of after-tax funds. This means that 25% of the amount converted is tax free.
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