What Is the Pro Rata Rule for Roth Conversion

In your example above, after tax, what is the status of the funds? Here`s my understanding based on the pro-rata rule: Step 4. The non-taxable portion of distributions (and conversions) during the calendar year is determined by multiplying the percentage of Step 3 by the amount of the distribution or conversion. The remaining portion of the distribution is taxable income. Entered on Form 8606 line 11 (see Form 2020 8606 above). There are four steps in the „pro rata” process that lead to determining the taxable and non-taxable portions of a traditional IRA distribution or Roth IRA conversion. Note that the prorated calculation is done using the corresponding IRA balances at the end of the calendar year (December 31) and covers all traditional IRA distributions made that year. These steps are described below. The pro-rata rule states that the taxation of IRA accounts, if they are partially or fully converted into Roth accounts, is calculated in proportion to the proportion of after-tax and pre-tax contributions. The percentage of funds that still need to be taxed is prorated, whether you transfer all or part of your accounts at the same time. Note that the conversion must fall into one of the following options: The pro-rata rule prevents people from converting only non-deductible (after-tax) IRAs to Roth IRAs, thus avoiding the taxes that would normally be associated with the conversion process.

This rule requires you to consider ALL your IRAs as the same account. So, if you have a traditional IRA, IRA rollover, SIMPLE IRA or SEP IRA, these balances will be taken into account when it comes to determining your tax liability for the conversion. Keep in mind the 5-year rule, which imposes a five-year waiting period before converted IRA gains or funds can be withdrawn from the account. To withdraw income from a Roth IRA without incurring taxes or penalties, you must be at least 59 and a half years of age and have held the account for at least five tax years. If the funds are withdrawn earlier, you may have to pay income taxes and may have to pay a 10% penalty unless you are 59 and a half or older. In addition, it is important to recognize that, unlike 401(k) pro-rata distributions and similar plans that can be divided under IRS 2014-54 (and therefore the pre-tax portion of a distribution and the after-tax portion of a distribution may be sent to separate locations), the pre-tax and after-tax portions of an IRA distribution on a pro rata basis, essentially „plugged in” together. True, she would pay a tax rate on taxable income of $48,000 conversion than she would otherwise have in retirement, but only 60% of the total conversion balance of $80,000 would be taxable! Simply put, the pro-rata rule states that if a distribution is made by a traditional IRA that includes both pre-tax and after-tax dollars, the distribution consists of a ratifiable (proportional) amount of each. In summary, Roth IRAs can be a very powerful tool for retirement provision. It`s never a good feeling to be excluded from participating in something that can benefit us.

The income restrictions imposed on Roth IRAs were a sore point for many. While I try to remind people that stopping participating in a Roth IRA can be a good problem, not everyone is happy with this prospect. Before starting a Roth IRA conversion, proceed with caution, the pro-rata rule is hidden. In September, House Democrats proposed several changes to tighten the rules for Roth IRAs behind the back door. The law would prohibit people earning more than $400,000 a year from converting pre-tax retirement accounts into a Roth IRA. Most of the changes would begin in 2022. To continue with our previous example, we will deposit $161,000 in pre-tax dollars in Barbs 401(k). We can do that because employer plans are not subject to the pro rata rule. We can also perform this rollover with 403b, 457, solo 401(k) and some pension plans under this rule. This pre-tax withdrawal of funds on the 401k is a tax-free event that allows us to seamlessly withdraw pre-tax funds from the IRA while continuing to grow in a separate pre-tax account. Example 5: Remember Ben from the previous example, who converted the $310,000 from his traditional IRA into his 401(k) plan to isolate the $40,000 of after-tax money in his IRA to complete a tax-free Roth conversion in March of this year. Suppose the Roth conversion was subsequently completed on September 1, 2020.

Specifically, IRS Communication 2014-54 approved that the after-tax portion of a plan distribution may be separated from the input tax portion of those distributions so that each can be sent to a separate destination. Which, in the past, could mean transferring the input tax portion to a traditional IRA and keeping the after-tax dollars in a current account for a retiree. But for those who don`t need the money yet, it`s now also an option to transfer the pre-tax portion to a traditional IRA and extend the after-tax portion. to a Roth IRA (as a tax-exempt Roth conversion!). In contrast, transferring funds from an employer-sponsored plan into a traditional IRA in the calendar year following the completion of an IRA conversion to Roth IRA (or at any time thereafter) does not result in the same complications. The „pro rata rule” is used to calculate the amount of a taxable traditional IRA distribution when a traditional IRA owner has pre- and post-taxed funds in their traditional IRA. The rule is also used to determine how much of a traditional IRA is taxable when converted to Roth IRA. That is, how much of a person`s „cost base” is returned. Only traditional IRA owners who have post-tax contributions in at least one of their traditional IRAs are affected by the pro-rata rule. Roth IRA Backdoors are worth considering for your retirement savings, especially if you`re high-income. A backdoor-Roth conversion may be something to consider if: Thank you David.

I found information that confirms your claim: it is still considered an IRA fund and is therefore included in the pro-rata calculation. On the other hand, if Ben had only waited one more month and completed the same rollover in January 2021 (the calendar year following the completion of his IRA conversion to Roth IRA in December 2020), the full conversion would have been a tax-free conversion of after-tax funds. When parts of the same IRA distribution are found in multiple destinations (for example. B, a traditional IRA, a Roth IRA, the „pocket” of the IRA owner), each destination typically receives a ratifiable amount of prorated input tax and after-tax dollars. Therefore, someone who only has a limited amount of pre-tax dollars in a primarily after-tax IRA could siphon off some or all of the pre-tax money with a QCD and then, much like the rollover strategy to an employer-sponsored pension plan – make a Roth conversion to the rest, which would be after tax only at this point. Or, even „only” reducing the portion of an account that contains a mix of before- and after-tax dollars by using QCDs for at least a portion of the pre-tax dollars can make Roth conversion math more appealing. Hi Nick, Thank you for commenting and participating in the conversation. I am not sure I am following the question well. I will say that a distinction must be made between the conversion of all input tax dollars and non-deductible amounts. The pro-rata rule deals specifically with the non-deductible contribution compared to other pre-tax IRAs. In the coming years, the calculation will be done again and will reflect the new balances (account values).

The whole point of the pro-rata rule is to ensure that people do not avoid tax by converting only non-deductible contributions. I recognize that this may not fully answer your question. You are invited to make an appointment with you to clarify your situation. Send me an email and we`ll schedule it. It is very affordable and will help you not to make a costly mistake. Let me know. One of the most important rules that are relevant to Roth`s backdoor conversion is the pro-rata rule. A Roth IRA backdoor conversion is a method used by high-income individuals to bypass Roth IRA income limits set by the Internal Revenue Service (IRS). The „back door” path is accessible, regardless of your income level.

If done correctly, a traditional non-deductible IRA can be converted into a Roth IRA and no income tax has to be paid. This is called the Roth IRA „backdoor” conversion. Instead of contributing directly to a Roth IRA that a person may not be eligible for (due to the excessive income of the person who walks through the „front door”), the person instead converts the traditional non-deductible IRA into a Roth IRA (to which every person is eligible, regardless of age, whether or not they participate in an employer-sponsored pension plan). the amount of their annual income). Ben is currently in the regular 24% tax bracket and expects to be in the 12% income tax bracket in retirement. Therefore, an IRA to Roth IRA conversion would generally not be recommended at this time. Taxpayers must track the after-tax balances of IRA accounts on IRS Form 8606. The form must be completed with the tax return each year the taxpayer makes an after-tax contribution (or is transferred after-tax funds from an employer plan to their IRA), and it must be filed each year following that a distribution is deducted from the IRA.

The form uses prorated calculation to determine the amount of the taxable distribution. The formula for prorated calculation is the total after-tax currency in all IRAs divided by the total value of all IRAs multiplied by the amount converted….

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