Widget Jerry Meets the Pro-Rata Rule
By Andy Ives, CFP®, AIF®
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Jerry sells widgets for the ACME Widget Company. Jerry is a hard-working employee who participates in the ACME Widget Company 401(k) Plan. Jerry also contributes annually to an IRA account at a local bank.
The widget business is a fickle one. Some years Jerry can make up to $200,000, while in the down years he might only make $50,000. When Jerry’s income is high, he cannot deduct his IRA contribution because he is an active participant in his employer’s 401(k) plan. In those years, he makes nondeductible contributions to his IRA and diligently files Form 8606 to report them as such.
In the slow years, when Jerry and his wife’s income is below the deductibility phase-out range for active participants, Jerry contributes to his IRA and takes the appropriate deduction on his taxes. Jerry maintains excellent records and knows exactly how much deductible vs. nondeductible money he has in his IRA.
Jerry retired from the ACME Widget Company at age 65 and rolled his entire 401(k) plan – exactly $600,000 of pre-tax money - into his IRA. The split in Jerry’s IRA looks like this:
$600,000 – Pre-tax 401(k) rollover dollars
$100,000 – Deductible (pre-tax) contributions and earnings
$300,000 – Nondeductible (after-tax) contributions
After many years of selling widgets and diligently saving, Jerry is ready to take his wife on fabulous vacations and live off his IRA money. He withdraws $10,000 from the IRA and asks the bank to report it as a withdrawal from the after-tax, nondeductible $300,000 portion of the account. “After all,” Jerry reasons. “Why pay taxes now? Might as well use up my three-hundred-K of after-tax dollars first.”
Uh-oh. Jerry may know everything about widgets, but he is about to get a lesson on the pro-rata rule.
When an IRA contains both nondeductible and deductible funds, each dollar withdrawn will contain a percentage of tax-free and taxable funds. This percentage is based on the ratio of after-tax funds vs. the entire balance in all your IRAs. You cannot withdraw (or convert) just the nondeductible funds and pay no tax.
Since Jerry’s rollover 401(k) money and deductible IRA contributions make up 70% of his $1,000,000 IRA, then $0.70 of every dollar he withdraws will be taxable. If he is in the 22% bracket:
$10,000 withdrawal X 70% = $7,000.
$7,000 X 22% = $1,540 taxes due
What if Jerry had maintained two different IRA accounts at the bank – one for deductible contributions and one for nondeductible? It matters not. The pro rata rule states you must include the balances of all IRAs, even if they are in separate accounts (including balances in SEP and SIMPLE plans).
Inherited IRA accounts and Roth IRAs are not included when determining taxation on a distribution from a traditional IRA. Also, had Jerry left his 401(k) money in the ACME plan and not rolled it into his IRA, those 401(k) dollars would be excluded from the pro rata calculation on his IRA withdrawal.
(Widget Jerry didn’t take it too hard. He withdrew additional IRA dollars to make up for the shortfall due to taxes, suggested to the nice bank lady that she consider replacing her widget, and had a wonderful trip with his wife.)
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