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.
Full Video Transcript
00:00:00:00 - 00:00:17:01
So you're trying to get more money into your Roth IRA, but you just earned too much and now you're trying to do a backdoor Roth. But you've come across this pro rata role and you're trying to figure out what is the pro-rata rule, what's this formula, and how do I figure this out and how much taxes am I going to pay?
00:00:17:12 - 00:00:36:09
So in this video, we're going to talk about what the pro-rata rule is, what the formula is. I'm going to go for an example. And last but certainly not least, I'm going to show you how to avoid all of this avoid the pro-rata rule, avoid the extra taxes. What's going on? Guys, welcome back to the Channel or if this is your first time at our channel.
00:00:36:10 - 00:00:57:16
Welcome to the channel. My name is Travis Sickle. And let's go ahead and get started. So let's start at the very beginning. You've realized that you can't make a direct contribution into the Roth IRA, but you still want to figure out how to get money into the Roth IRA. So those income limits is something that you need to be aware of.
00:00:57:16 - 00:01:17:06
So they go ahead and pull those up on the screen here. And if you scroll down, this is my blog, I've put them right here. And for the Roth IRA, income limits for somebody that's filing single in 2022 if you earn over $144,000, you can't make a direct contribution into the Roth IRA. In between these two limits is to phase out.
00:01:17:06 - 00:01:43:17
So that means a reduced amount and for married filing jointly that's $204,000 to $214,000. So if you earn $214,000 or more you can't make a direct contribution if you're married filing jointly. And you can see those contribution limits are exactly the same at $6,000 for 2021 and 2022. So those are the income limits for the direct contribution into the Roth IRA.
00:01:43:18 - 00:02:15:26
But now you know that you're over those thresholds. You're trying to do this backdoor Roth and this whole pro-rata rule thing. So I've kind of drawn it out here for you. So we can go through this together. And right here you can see that we have an IRA and our Roth over here. Now, the pro-rata rule basically says that your aftertax contribution also called a nondeductible contribution into your traditional IRA that probably already has existing pretax money in it.
00:02:16:05 - 00:02:40:06
So let's say that we have $100,000 inside as pretax contributions, including growth inside of your IRA. Well, when you make that aftertax contribution and let's say that we did the full $6,000, we can't cherry pick and takes this $6,000 and just put it over to the Roth IRA. Well, that would be nice. It's not the way things work.
00:02:40:14 - 00:03:06:19
This is the pro-rata rule where we have to take an equal amount from the pretax portion and the after-tax portion. So in actuality, in order to get this full $6,000 over to the Roth, we have to convert this full amount over to the Roth in order to bring this $6,000. Now, the problem with that is that this $100,000 is pretax money.
00:03:06:23 - 00:03:39:24
That means in the year that you're doing this conversion, that full $100,000 will then get added to your taxable income. Now you can convert is little or as much as you want, but each dollar is still going to be a prorated amount, an equal portion from your nondeductible, from your after-tax contribution and that pretax amount. Now, this includes all of your IRAs, whether they're SEP IRAs or SIMPLE IRAs, or even if you have ten different traditional IRAs, it doesn't matter.
00:03:40:02 - 00:04:08:01
The formula is going to include all of those IRAs as one single IRA. So there's no way to split up your IRAs in order to avoid this pro-rata rule. So now let's go over the formula and then we'll go through an actual example on how this all works. So the pro-rata rule formula is your aftertax contribution. Divided by your total IRA balance.
00:04:08:02 - 00:04:43:27
Now, remember I said your total IRA balance is all of your IRAs, including SEP IRAs and symbols. And this is going to equal the percent of conversion that is not taxable. So if we go back to the other example that we just drew out and I'll bring it up on the screen here and we have our $100,000 in our $6,000 after-tax, our total IRA right now has 106,000 So for the pro-rata rule, we want to take the after-tax contribution and divide that by the total balance.
00:04:43:28 - 00:05:17:05
So in this case, it's going to be our after-tax contribution of $6,000 and we're going to divide that by $106,000. And that is going to equal if we take out our calculator, I'm just going to show you how to do the math. $6,000 divided by $106,000 is .06. And then if we take that, let's say that we only want to convert $1,000 of this total amount.
00:05:17:15 - 00:05:51:05
That means we're going to take 0.06 and multiply it by $1,000. So we'll do $1,000. Times .06. And that's going to be $60. $60 of the $1,000 is not taxable. That means the other $940 is taxable as ordinary income in our conversion. Now, there's a couple of points that you need to be aware of, no matter when you did the conversion the pro-rata portion is as of December 31st in the year of conversion.
00:05:51:13 - 00:06:28:26
So if you think about that for just a second, that means you're going to do this formula after you do your conversion. So while you might have an idea of how much is going to be taxable or not taxable, you're not going to know exactly until December 31st of the year that you're doing that conversion. And another question that you might have is the growth portion to the Nondeductible contribution So if you make that nondeductible contribution, say, in January or February, and then you do the conversion in, say, June, and there were some growth in there, that growth portion just gets added to the pretax side.
00:06:28:26 - 00:07:02:15
That's how you should be looking at it because it's going to be taxable. So the only amount that you're including as a nondeductible contribution is only that contribution, not the growth, not the attributable growth or any growth inside of that IRA. That will just get added to the pretax side in your formula. So it's rather simple when you're figuring out how much you're putting in as a nondeductible contribution and doing that ratio and then doing the conversion to figure that out.
00:07:02:15 - 00:07:23:14
And as I mentioned in the beginning of the video, there is a way around the pro-rata rule and avoid these extra taxes. And they actually did a completely separate video in walking you through and how to avoid those extra taxes when it comes to the pro-rata rule. It has to do with your retirement plan and rolling your current IRA.
00:07:23:24 - 00:07:45:11
All your IRAs into your current workplace plan. But you can also look at my personal favorite, the solo 401K, but I will leave a link in the description at the bottom to that video so you can walk yourself through it. And if you have any questions, let me know in the comments down below. And if you've enjoyed this video, be sure to subscribe and we'll see you on the next one.
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 | 2022 Roth IRA Income Range | 2023 Roth IRA Income Range |
|---|---|---|
| Single | $129,000-$144,000 | $138,000-$153,000 |
| Married Filing Jointly | $204,000-$214,000 | $218,000-$228,000 |
| 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.