4 Things to Know About Roth IRA Conversions and Pro-Rata Rule | Ed Slott and Company, LLC

4 Things to Know About Roth IRA Conversions and Pro-Rata Rule

By Beverly DeVeny, Chief IRA Analyst
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@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.

  1. 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.
     
  2. 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.
     
  3. Your conversion and the pro-rata calculation are both reported on IRS Form 8606, which must be filed with your income tax return.
     
  4. 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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