Backdoor Roth IRA Pro Rata Rule Explained
The Pro Rata Rule is required when you convert a traditional retirement plan, whole or in part, to a Roth IRA and the traditional IRA has both aftertax and pretax money.
The premise of the pro rata rule is to prevent higher-income earners from taking advantage of the backdoor Roth conversion without incurring additional taxes.
First, let's talk about how the pro rata rule works, then the formula and finally we will cover a few examples.
The Roth IRA Income Limits
The first place we're starting are the Roth IRA income limits. Depending on your income and filing status will determine if you're eligible to contribute directly to a Roth IRA.
If you're above these limits, you may still be able to contribute to a traditional IRA by way of a nondeductible contribution and later convert to a Roth IRA, also known as a backdoor Roth conversion strategy.
|Filing Status||2021 Roth IRA Income Range||2022 Roth IRA Income Range|
|Married Filing Jointly||$196,000-$208,000||$204,000-$214,000|
|Married Filing Separately||$0-$10,000||$0-$10,000|
The Backdoor Roth IRA
When you are over the income limits of making a direct contribution to a Roth IRA you may be able to complete a backdoor Roth conversion. It's simply, making a nondeductible contribution to your traditional IRA and then converting it over to a Roth IRA. However, if you have existing pretax money inside the traditional IRA, you will need to take a prorated amount from the pretax and after-tax amounts. When converting the pretax amount to a Roth IRA, the result is a taxable situation.
The Pro Rata Rule
The pro rata rule takes an equal portion of pretax and after-tax money across all IRAs of the account holder. All IRAs, including SEP IRAs and SIMPLE IRAs, are included in the calculation. There is no way to cherry-pick which IRAs are included or not.
The Pro Rata Rule Formula
The formula is calculated by dividing the nondeductible contributions in the IRAs by the entire balance of all IRAs. The IRAs include all IRAs of the account holder but not the spouse IRAs. The result is the percentage of the conversion that is not taxable.
The Pro Rata Rule Example
Assume you have an existing IRA with all pretax contributions valued at $100,000. If you contribute $6,000 as a nondeductible contribution, that equals a total balance of $106,000. Dividing the $6,000 nondeductible contribution by $106,000 equals .06 or 6%. If you converted only $1,000 then $1,000 x 6% is $60, which is the nontaxable amount of the conversion. The remaining $940 is taxed as ordinary income in the year of the conversion.
Even if you converted the entire $6,000 to the Roth IRA, only a portion is considered nondeductible and will still include a taxable amount. The pro rata rule would require converting the full $106,000 in order to convert the entire nondeductible contribution.
The way to avoid the pro rata rule is to remove all pretax money from all IRAs. I'm not talking about a distribution from the IRA, but a rollover to a retirement plan other than an IRA, such as a 401k or 403b.
The pro rata rule is calculated based on December 31st balances after the taxable year. Once a conversion is completed, it can't be recharacterized.