Roth backdoor conversions are subject to the pro-rata rule, which dictates how non-Roth IRA funds are taxed on payment. Some retirement savers believe they can contribute after-tax to a traditional IRA and then convert the funds to a Roth IRA to circumvent Roth IRA income limits and benefit from tax-free growth, but the pro-rata rule prevents them from doing so. Instead, the IRS requires taxpayers to calculate their taxable contribution percentage and pay a proportionate amount when withdrawing tax-advantaged accounts. This can complicate matters and result in an unexpected tax bill for the negligent. Since the pro-rata rule states that conversions are proportional, you also can`t move funds invested in a fund that has a loss to avoid paying taxes on the profit share. If you have multiple traditional IRA accounts, the taxable portion of a conversion is determined based on the assets and income of all your accounts – prorated to the amount you convert. However, 401ks before taxes are not included in the prorated calculation. The pro rata rule specifies that conversions must be proportional. Each conversion would therefore involve a proportional mix of pre- and post-tax funds.
The input portion of the conversion and all income from the after-tax portion are taxable in the year in which you convert to Roth. A much bigger impact of this rule comes to those who decide to renew a 401(k) or another type of business plan. Only the total value of IRA accounts is used in the prorated rule. 401(k) budgeted values, 403(b) plans, and profit-sharing plans are not included in the prorated formula. The value of any of these account types would be included if you decide to transfer plan assets to an IRA during the year. Roth IRAs are tax-funded retirement accounts that allow you to collect after-tax money without paying more taxes in retirement. Therefore, they are subject to specific rules governing tax-free withdrawals. In your example above, after tax, what is the status of the funds? Here is my understanding based on the pro-rata rule: Question about this scenario, how it appeared for me recently. I received additional pension funds from a previous employer.
This employer took those funds and put them in a traditional IRA. I`m not interested in investing after-tax (non-deductible) dollars in a traditional IRA and immediately entering the ROTH IRA. Obviously, I want to avoid prorated or triggering with the IRS, so I thought I should be able to 1) take the original traditional pre-tax IRA issued by a previous employer and ride in my existing pre-tax 401k 2) enter 6k into the traditional IRA and roll into a Roth IRA immediately. one way to reduce the impact of the prorated rule is to increase the total amount of your pre-tax IRA, and this can be done by transferring those IRA funds into your company`s 401k plan if your business allows it. My question is: Does transferring pre-tax IRA funds into an immediate annuity (with lifetime payments) also exclude those funds from the prorated calculation? The prorated rule specifies how the Internal Revenue Service handles before and after tax contributions when the customer performs a Roth conversion. Thank you David. I found information that confirms your claim: it is still considered an IRA fund and is therefore included in the prorated calculation. By Andy Ives, CFP®, IRA analyst at AIFEZ us®on Twitter: @theslottreportSCENARIO: Teddy, 60, already has a traditional IRA with a current balance of $93,000. This is money that is deductible before taxes. Teddy would like to contribute to a Roth IRA, but his income level exceeds the Roth IRA income limit.
To get around this, Teddy is making a non-deductible contribution of $7,000 to his traditional IRA in 2021 with the idea of hiding the $7,000 as a Roth backdoor. Teddy mistakenly thinks his $7,000 conversion will be tax-free. He is surprised to learn that the majority of the conversion is actually taxable. Teddy complains that he is being taxed twice because he “has already paid taxes on that $7,000 basis.” Teddy doesn`t understand the pro-rata rule. It is not imposed twice. The pro-rata rule states that if an IRA contains both non-deductible and deductible funds, every dollar withdrawn (or converted) by the IRA includes a percentage of tax-exempt and taxable funds. This ratio is based on the percentage of after-tax dollars on the total balance sheet of all of an individual`s traditional IRA, SEP and SIMPLE plans. Teddy can not only choose the after-tax funds and simply convert them.
It would also make no difference if Teddy donated the $7,000 to a completely different IRA at another custodian. The IRS considers all IRAs, SEPs, and SIMPLE under a person`s name to be a big bucket of money. So what is the “pro-rata calculation” in Teddy`s Backdoor Roth conversion and how will his accounts play out after the trade? Teddy has no MS or SIMPLE plans. His only IRA is the one that had $93,000 of all pre-tax dollars.