Roth Conversions and the Pro-Rata Rule
By Beverly DeVeny, IRA Technical Expert
Follow Me on Twitter: @BevIRAEdSlott
For IRA distribution purposes, all IRAs (except Roth IRAs) are considered one big giant IRA. It doesn’t matter if you have one IRA that was rolled over from a former employer, and one SEP IRA with your current employer, and one contributory IRA where you put annual contributions, and one after-tax IRA where you put contributions for which you do not take a deduction. All four IRAs will be considered one IRA any time you take a distribution.
Since they are all one IRA for distribution purposes, you cannot separate out any one component of your IRAs. You cannot take out or convert only the after-tax funds in your IRA. All distributions or conversions will be treated pro-rata.
You track your after-tax IRA funds on IRS Form 8606. The form must be filed with your tax return in any year that you make an after-tax contribution (or rollover after-tax funds from an employer plan to your IRA), and it must be filed in any following year when you take a distribution from your IRA. The form will calculate the amount of your distribution that is taxable.
Put simply, the form takes the total year-end balance of all your IRAs and divides that into the total balance of all after-tax amounts in all IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the distribution. The remaining balance of the distribution is taxable. The tax-free amount of the distribution will reduce the total after-tax amount carried forward to your next Form 8606.
Example: John has a rollover IRA from a previous employer of $270,000 and an “after-tax” IRA account with $30,000 of total contributions in it. John takes a distribution of $30,000 from his after-tax account and converts it to a Roth IRA. His total account balance is $300,000 ($270,000 + $30,000 = $300,000). 10% of his distribution will be tax free ($30,000 / $300,000 = 10%). He will pay income tax on $27,000 ($30,000 X 10% = $3,000 tax free, balance $30,000 - $3,000 = $27,000 taxable). Even though he has closed his after-tax IRA, his rollover IRA balance will now include the remaining after-tax balance of $27,000 ($30,000 after-tax balance - $3,000 distributed = $27,000).
As you can see from the calculation, it won’t matter what IRA account you take the distribution from. Some of the distribution will be taxable and some will be tax-free. The overall totals of your pre-tax and after-tax amounts will be reduced without regard to the account the funds came from.