Exceptions to the Pro-Rata Rule for IRA Distributions
By Sarah Brenner, IRA Analyst
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Have you ever made non-deductible IRA contributions? Or, rolled over after-tax funds from your company plan to your IRA? If so, you will want to know about the pro-rata rule. The pro-rata rule almost always determines the taxation of an IRA distribution when the IRA owner has any IRA containing after-tax amounts. However, some IRA distributions are not subject to the pro-rata rule. These exceptions may provide an opportunity for you to lower the tax bill that comes with an IRA distribution or conversion.
How the Pro-Rata Formula Works
You may have more than one IRA. For example, you may have an IRA that was rolled over from a former employer, a SIMPLE IRA with your current employer, an IRA where you make annual deductible contributions, and a IRA where a long time ago you made some contributions for which you did not take a deduction. Usually, when you take an IRA distribution, all of your IRAs (except Roth IRAs) are considered one big IRA.
With the pro-rata formula, you take the total year-end balance of all of your IRAs and divide that into the total balance of all after-tax amounts in all of your IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of your distribution. The remaining part of the distribution is taxable. You cannot separate out any one part of your IRAs and select that part to be your distribution. You cannot take out or convert only the after-tax funds in your IRAs. You must use the pro-rata formula.
Exceptions to the Pro-Rata Rule for IRAs
While most IRA distributions are subject to the pro-rata rule, you should know that there are some exceptions. Distributions that are not subject to the pro-rata rule include:
- Qualified Charitable Distributions (QCDs) - If you are age 70 ½ or older, you can transfer up to $100,000 each year from your IRA to a charity tax-free.
- Qualified HSA Funding Distributions (QHFDs) – You are permitted to do a QHFD once in your lifetime. This is a tax-free transfer from your IRA to your HSA. The amount that can be transferred cannot exceed the amount you're eligible to contribute to your HSA for the year.
- Rollovers to Company Plans – You may rollover your taxable IRA funds to your company plan if the plan allows.
You can only fund each of these distribution with the taxable part of your IRA. The pro-rata rule will not apply. Instead, the distribution will consist only of taxable IRA funds.
Example: Judy has $150,000 in her only IRA. Her IRA includes $50,000 in after-tax funds. Judy’s company plan allows rollovers from IRAs. Judy rolls over $100,000 to her company plan. The pro-rata formula does not apply. Instead, the entire $100,000 amount will be pre tax. This means that the $50,000 left in Judy’s IRA is considered to be after-tax funds. Judy will not have a tax bill when she takes any of these funds from her IRA, or if she decides to convert.
Opportunity for a Smaller Tax Bill
If you are eligible, using one of these three exceptions can pay off when it comes how your IRA distributions are taxed. You can move your taxable IRA funds out of your IRA. This means that a greater percentage of what's left behind will be after-tax funds. When you convert or take a distribution, this means that less will be taxable. A smaller tax bill is good news for you. Want to learn more and find out if this is a good strategy for you? A good move is to discuss your situation with a tax or financial advisor who is well versed in the IRA rules.
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